Stop-loss orders: pros, cons and gaps

A stop-loss order is an instruction to sell a holding if its price falls to a level you choose. It is designed to limit a loss and to take a difficult decision out of the moment. What it does not do is guarantee the price you will actually receive, which is the most important thing to understand before relying on one.

How the main types work

For the basics of order types, see market, limit and stop orders. The three used for stop-loss purposes are:

Brokers differ in details, including which price triggers the stop (last trade, bid, or ask) and whether stops are active outside regular trading hours. Many standard stop orders are only active during regular hours, so check your broker's rules.

Example (illustrative numbers)

You buy a stock at $100 and place a stop at $90, intending to cap the loss near 10%.

• Normal decline. The stock drifts down through $90 during the day. The stop triggers and fills at about $90. The plan worked.
• Overnight gap. The stock closes at $95. After the close, the company reports bad news, and the next morning the stock opens at $80. The stop triggers at the open and a stop-market order fills near $80: a 20% loss, not 10%.
• Gap with a stop-limit. If you had a stop-limit with a limit of $88, the order would trigger but never fill, because the price opened below the limit. You would still hold the stock at $80, with no protection if it kept falling.

Gaps are common around earnings releases and other news that comes out when the market is closed. See pre-market and after-hours trading for why those hours matter.

Potential benefits

• Discipline. A stop set in advance replaces an emotional decision with a rule.
• Defined risk per position. It pairs naturally with position sizing, since the distance between entry and stop sets the dollar risk per share.
• Less screen time. The order is monitored for you.

Limitations and risks

• Gaps. As in the example, the fill can be far from the stop price.
• Whipsaws. Stocks fluctuate for ordinary reasons. A stop placed within normal daily movement can be triggered by noise, after which the price recovers and you are out of a position you wanted to keep. Basing the distance on typical movement, using a measure such as average true range, helps avoid a stop that is too tight.
• Crowded levels. Many traders place stops at the same obvious spots, such as just below a recent low or a round number. A break of support can bring a rush of sell orders at once.
• Fast markets. In extreme episodes, stop orders can become market orders at poor prices. During the "flash crash" of May 6, 2010, prices of some stocks fell far and fast within minutes, and some stop orders were executed at prices well below where the stocks had traded shortly before.
• Thin trading. Stocks with wide spreads and low volume can fill at prices well away from the last trade. See bid-ask spread and liquidity.
• Realized taxes. A stop sale is a sale, so it can realize a gain or loss in a taxable account. If you buy back the same security within 30 days of selling at a loss, US wash-sale rules can disallow the loss for tax purposes. See capital gains and dividend taxes.
• Mismatch with a long-term thesis. If you own a business because of its long-run value, a short-term price drop may be noise rather than new information, and a stop may sell exactly when the stock is cheaper.

Ways to choose a stop level

There is no correct number. Common approaches:

1. A percentage from entry. Simple, but not tied to how the stock actually moves.
2. A multiple of recent volatility. Placing the stop a few average true ranges below the price allows for ordinary swings.
3. A technical level. Just below a prior low or a key moving average, if your method uses chart levels.
4. A level where the thesis breaks. The price at which the facts that justified the purchase would no longer hold.

Alternatives and complements

• Size the position so the worst case is acceptable, with no stop at all. A small position needs less protection.
• Use price alerts instead of automatic orders, and decide manually when the alert fires. This avoids automatic sales but depends on your response.
• Use options. Put options can set a floor on a loss, but they have costs and complexity beyond this article.
• Review on a schedule or on news, rather than on price alone.

Key takeaways

• A stop-loss order triggers a sale at a chosen price but does not guarantee the sale price.
• Overnight gaps and fast markets can produce fills far below the stop; stop-limits may not fill.
• Stops placed inside normal volatility tend to be triggered by noise.
• Stops work best as one part of a plan that includes position size and a clear reason for owning the stock.
• Taxes, including the wash-sale rule, apply to stopped-out sales in taxable accounts.