A stop loss trade is one that is made in order to set a limit to the loss made by an adverse price movement. For instance, an investor who buys a share at 100p may decide to sell if the price falls below 80p so that the maximum loss will be 20p per share (or 20% of the amount invested) plus trading costs.
It is possible to enter orders that execute when the price reaches certain levels, thus automating the stop loss process. An investor then does not have to keep checking security prices, merely choose a stop loss price.
One problem is that there is no guarantee that it will be possible to sell at the stop loss level. If a share price collapses suddenly it may only be possible to find buyers well below the stop loss price.
It is possible to guarantee price by using a stop limit order. That, however, raises the risk that the order will not execute because the price drops below the limit before the order executes. A stop loss transaction need not be a sale as short selling losses can be limited by a stop buy.
Market crashes can be exacerbated by the widespread use of stop loss strategies, in particularly where the trades are automated.
Stop Loss Order Types
- Market Stop Orders
This is a conventional stop loss order – the stop activates a market order to sell (or buy) at the prevailing market price. - Limit Stop Orders
The limit stop activates an order to sell at the prevailing market price but not below a specified limit (or buy at the prevailing price up to a specified limit). - Fixed Price Stop Orders
The stop loss activates an order at a fixed price. Some exchanges refer to these as limit stop orders so check that you are using the correct stop loss order.
Limit stop orders are recommended for entering a trade: they have a greater chance of success than fixed price orders but are not as open-ended as market orders (where your order will be executed no matter what the market price is).
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