Stop Loss Order

With a stop loss order, it is necessary that you thoroughly understand market orders so that you will not become confused.  As a reminder, a market order is simply instruction from your stockbroker to either purchase or sell as certain stock.

When a stop loss order is placed it instantly becomes a market order when a pre-calculated price is reached.  At that point, the typical rules of a market order come into effect, meaning that the order is virtually guaranteed to be executed.

The gamble here is that you don't know the price.  Because you have set a predetermined price, and the stock has reached that point, it does not guarantee that by the time a stop loss order is placed that it will be that price.  The tricky part of a stop loss order is that a certain stock may reach the predetermined price, however, because the stock market fluctuates, by the time the stop loss order is placed, the stock price could have increase or decreased.

Investors choose to use the stop loss order in two distinct situations. The investor may use a stop loss order in order to try to reduce the amount of loss that could occur. For example, you purchase 500 shares of stock from Target, a discount store chain, and at the time of purchase you place a stop loss order on the total amount of stocks. Then, you predetermine that you will not sell any of your 500 shares of stock from Target until it gives you a total profit 75% higher than the purchase price.

Let's say that all 500 shares of stock from Target cost you $95 each, for a total of $47,500. You are not allowed to sell these stocks until you make a total profit of $78,375.  So, after 5 months of owning 500 shares of stock from Target, you earn that total profit and you sell your 500 shares of stock from Target.

By the time the transaction occurs, each stock drops in profit by 25%, therefore, you just saved yourself from losing a return on your investment. The other reason that an investor may choose to place a stop loss order is to protect their profit. You, the investor, are only willing to lose a certain amount of you initial investment, so you place a stop loss order on your purchase. 

For example, you decide to buy 25 shares of stock in Company Z, which are priced at $1.00 each, for a total investment of only $25.00.  You set a stop loss order on this stock purchase by determining that you are willing to lose only 20% of this total investment. Therefore, when you have lost a total of $6.25, then you are able to sell you stock to ensure that you will not lose any more profit due to the decreasing profits. 

As with the trailing stop order, the main advantage of the stop loss order is that you do not have to monitor your purchase on a daily basis. Because you have set a predetermined amount, when it is reached, the action of buying or selling will take place. Therefore, if you hold a demanding full time career, you do not have to watch the stock market daily in order to keep up with each of your purchased stocks.

The main disadvantage to keep in mind is that when your stop price is reached, buying or selling does take place, even if you have changed your mind and you want the investment to remain the same. This can be detrimental if a stock has shown no losses over a period of time. For example, you purchase 30 shares of stock from Company T and you place a stop loss order on it at the time of purchase.

As time elapses, you discover that Company T's stock has shown no losses but has instead should a steady gain in profits.  However, the stock has reached the stop price, so you must now sell a profit bearing stock. Thus, in the long-run, because you had to sell this particular stock, you are losing money on your investment.

This stop loss order can provide a massive amount of saving your profits, however, if used when not necessary, you will end up losing more money than you have gained.