How to Set up a Stop Loss When Trading

Investing in an individual stock can be terrifying. You never know if the stock will go up or down, and your anxiety tends to go with whichever way your investment moves.

Thankfully there is a way to check out of an investment early if it’s dropping in value. You will still lose money, but you won’t lose all your money. This is called a stop-loss order, and I’m going to unpack everything you need to know about it below.

What is a Stop-Loss Order?

A stop-loss order is a type of stock trade you can make to limit your stock losses. You do this by identifying a floor price you don’t want to sell below and setting up a stop-loss order to hedge your bets.

For example, if you bought Tesla at $1,000 and were unsure of how the market would move, you might want to cover yourself and set up a stop-loss order to sell the stock the moment it drops to a specific price.

Say you didn’t want to lose more than 20% on your investment. In that case, you’d set up a stop-loss order for $800 to sell Tesla. If and when the stock price of Tesla dropped to $800 (or slightly below, based on market fluctuations), your order would automatically be executed.

On a side note, you need to do a fair amount of research to determine how low your stop-loss order should be set. The example I gave was using arbitrary numbers. To get access to some excellent (and advanced) research tools, look into TD Ameritrade. They have some of the best — you can read our TD Ameritrade review to learn more about their features and how it works.

How Do Market Orders and Limit Orders Compare?

You may also hear the terms “market order” and “limit order” when you’re investing. It’s good to know all the different trade types before you jump in and start buying and selling stocks. These two specifically come into play with a stop-loss order, however.

Market Orders

A market order is when you place an order to buy or sell a stock at whatever the market price is. Some brokerages will be able to execute this for you immediately (assuming there is a buyer for the stock, of course).

The benefit of a market order is that you get your stock almost instantly, and you pay the current price you see (but it’s usually plus or minus a tiny percentage with most stocks based on how fast the market moves).

The downside to a market order is that you may not pay the exact price you want. You might overpay. People use market orders when they want to make a trade quickly or don’t care about the current price since they assume it’ll go up in the future.

Webull, for example, makes it easy to place market orders quickly using their app. Once you find the stock you want, you just tap “Order Type” to choose the type of order you like:

Webull has a lot of other features, too, including after-hours trading and advanced research tools. Check out our Webull review for more information.

Limit Orders

A limit order is when you set a specific price to execute a trade. Unlike a market order that can be executed at any price, a limit order allows you to set a firm price by which you want to sell the stock, and if the price hits that dollar amount (called the stop price), a limit order will be executed.

So rather than you saying, “hey, broker, sell my Tesla stock once the price hits $800 using a market order,” and the stock is sold at whatever price you get after it hits that point, a limit order will give you that price or better. It prevents what’s called slippage (getting less for the stock than you wanted).

How Do These Order Types Impact Stop-Loss Orders?

When you place a stop-loss order, you can do it as a stop-loss market order or a stop-loss limit order (or merely a stop-limit order). If you don’t care about the price you get once it hits a certain threshold, a market order will suffice.

But, using my Tesla example, what if the market is crashing quickly and you set the market limit order for $800, but you end up getting $500? It might sound unlikely, but if that’s the market price when the trade is executed, that’s what you’ll get. Alternatively, a stop-limit order will ONLY sell at the price you designate or better.

How Do You Set up a Stop-Loss Order When Buying?

Setting up a stop-loss order when buying a stock is relatively simple. Depending on the platform you use, you can almost always see the option for a stop-loss trade. Based on what I described above, it’ll often be called a “limit order.”

Using Zacks Trade, it’s pretty clear where you’ll click to make it a limit order (notice where my mouse hovers):

From there, you can enter your limit price and execute the order. If you want to make a stop-loss market order (which I don’t generally recommend), it’s often found under the “market order” type with most brokerages.

ZacksTrade is a more complex investment platform for advanced traders, so we recommend reading our ZacksTrade review before diving in.

How Do You Set up a Stop-Loss Order When Short-Selling?

Before you even consider this, make sure you completely understand the idea of shorting stocks. It can become incredibly confusing, and you can lose a lot of money if you don’t know what you’re doing.

Once you have a firm understanding, you can usually find the stop-loss order option when you place an order to short the stock. Ally Invest makes it easy to short stocks and place stop-loss orders on short-sells. Just review their guide on short-selling first, and be sure to read our review of Ally Invest.

Why Should You Use a Stop-Loss Order?

Placing a stop-loss order can be a smart idea if you aren’t sure how the stock will perform. It’s a great type of order for newer investors or investors with a lower risk tolerance, too.

Often, we buy stocks based on the hype surrounding them rather than the company’s real potential to perform. So if you buy Apple at $150 and you see that the stock very recently was at $120, you might place a stop-loss order for $120 (or just below that – more on the “swing low” strategy below).

This may give you a comfort level knowing that, while you lost on the stock, you haven’t lost everything you invested. And the price you sold it at was at least a reasonable one (since it hit that level in the recent past).

Why Shouldn’t You Use a Stop-Loss Order?

For those who are more familiar with investing and can stomach losses a bit more (or you just have a higher tolerance for risk), a stop-loss order may hurt you with a long-term investment strategy.

For example, say you’re keen on Apple (AAPL). It’s currently at $132 as of this writing, and maybe that’s a price you think is fair. But you have a long position on Apple. Meaning, you want to buy and hold the stock for a long time because you know it’ll grow exponentially in value over time.

So you don’t place a stop-loss order and instead buy the stock at $132. Then, say the market takes a hit, and AAPL drops to $80. Based on the type of investor you are, you will look at this one of two ways:

  1. The sky is falling, and I need to get out of this stock, or
  2. AAPL is cheap, and I want to buy more

The former is the mindset of a newer investor or someone with a lower risk tolerance. And it’s not a wrong mindset at all – just a perspective that might prefer to use a stop-loss order. The latter is someone with a higher risk tolerance and a long-term view of the stock.

So if you’d placed a stop-loss order for AAPL to sell at, say, $90, you might feel good knowing that you got out before it dropped further to $80. But if you’re taking a long-term view of this, maybe you instead buy MORE of AAPL stock now that it’s only $80 a share.

Now, what if AAPL bounces back the next day, week, month, or year? Or even in 5 years? Say in 5 years, the stock is up to $250. You’ve more than tripled your investment based on that $80 price point.

The stock market works in mysterious ways, so before placing a stop-loss order, know that neither mindset is wrong. It just depends on what you want to do with your investment.

Related: How to Handle Stock Market Volatility

What Else Should I Consider With a Stop Loss Order?

The main thing you need to know with a stop-loss order is WHEN to execute the trade. You shouldn’t take a blind guess on this and just pick a price you’re comfortable with. You should blend that price with data and research.

Look at the historical prices of the stock and research the investment before you buy. Are you overpaying or underpaying? It’s okay if you’re overpaying, but you have to have a strategy to make that money back, and you may want to set a lower bar for your stop-loss order.

The strategy to consider is the common-known “swing low” strategy. This means you should set a stop-loss price for slightly less than a recent low point or a low end you’re comfortable with to be able to sell as the stock is on an upswing.

You never want to sell as the stock is diving in value rapidly, like my example above with Apple. Sell as the stock hits its low point and starts to bounce back. This way, you might be able to buy back into that position if you want quickly, and you know the stock is seeing positive momentum.

Compare Discount Brokerage Accounts

Bottom Line

Remember that using a stop-loss is an option for you – you don’t have to do it. It’s something that you can leverage to mitigate your losses. I strongly recommend using these if you’re brand new to investing until you get the hang of how stock prices move.

But as you gain more experience, consider not using them and instead, keeping an eye on the market with a long-term focus for your investment strategy. Consider the example I gave with Apple above – you never know when stocks will rebound, you just have to do your research and watch closely.

Source link