A stop loss order is an order used to buy or sell as soon as a stock reaches a certain price level. Its name is exactly what it sounds like: It stops you from taking a catastrophic loss. A stop loss is an essential part of all risk management strategies. It is almost impossible to invest profitably without using one.
Why Use A Stop Loss?
A essential component of profitable investing is protecting yourself in the event of a market move against your position. This is exactly what a stop loss does. The stock market is random by nature, and not all of your investments or trades will go in your favor. In order to protect yourself in the worse case scenario, you put a stop loss order to limit your downside when a stock moves against you. A stop loss order will help you keep your losing investments much smaller than your winning investments.
Stop Loss Example
Let’s say you got long 100 shares of Facebook at $200 a share last year in 2018. You put a stop loss order at $195. This means in the worse case scenario you lose $500 a share. Facebooks ends up trading lower than $195 a share soon after, and you get stopped out.
Let’s imagine if you took this trade without using a stop loss. You would currently be down about $5000, with the stock trading at around $150 per share as we write this article. At one point you were down $7000 a share in December 2018. You are down more than 25% on your initial investment. You can see how much money a stop loss will end up saving you. Do not be reckless and trade without using one.
Different Types of Stop Losses
You can also use an order called a stop limit order to exit the market when a stock moves against. This works the same way a stop loss order does, except that it uses a limit order instead of a market order to take you out of the market. You will get less slippage with this type of stop loss order, but you run the risk of not being taken out of the market. Experienced traders will use mental stop losses, meaning they don't put in an order, but they have a price area in mind where they will exit their position. For more tips on how to place a stop order, check out this article here.
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