What is Stop Loss?
Definition
A stop loss is an order placed with a broker to sell a security when it reaches a specified price, designed to limit an investor's loss on a position. It automates risk management by ensuring positions are closed before losses become excessive.
Detailed Explanation
A standard stop loss (or stop market order) triggers a market sell order when the stock drops to the stop price. If you buy a stock at $100 and set a stop loss at $90, the position will be sold at market price once the stock hits $90. The actual execution price may differ from $90, especially in fast-moving markets or during gaps.
Stop-limit orders address the slippage risk by triggering a limit order instead of a market order. A stop at $90 with a limit at $88 means: once the stock hits $90, place a sell limit order at $88. This prevents selling at extremely unfavorable prices but risks no execution if the stock gaps below $88.
Common approaches for setting stop loss levels include: percentage-based (7-10% below purchase price), support-level-based (just below a key technical support), ATR-based (1.5-2x the Average True Range below the entry), and moving-average-based (below the 50-day or 200-day SMA). The best approach depends on the stock's volatility and the investor's time horizon.
Trailing stops move upward as the stock price increases, locking in profits while protecting against reversals. A 10% trailing stop on a stock that rises from $100 to $150 would be at $135 — protecting $35 of profit per share. Trailing stops are popular for trend-following strategies where the goal is to ride winners while cutting losers.
Example
You buy 500 shares at $80 and set a stop loss at $72 (10% below entry). If the stock drops to $72, the stop triggers and your shares are sold, limiting your loss to approximately $4,000 (500 x $8).
Frequently Asked Questions
Where should I place my stop loss?
Can a stop loss guarantee my exit price?
Related Terms
Volatility
Volatility measures the degree of variation in a stock's price over time. Higher volatility means larger and more frequent price swings, indicating greater uncertainty and risk. It is commonly expressed as the annualized standard deviation of returns.
Support and Resistance
Support and resistance are price levels where a stock historically tends to stop falling (support) or stop rising (resistance). These levels form because of concentrated buying or selling interest and are foundational concepts in technical analysis.
Market Order vs Limit Order
A market order executes immediately at the best available price, guaranteeing execution but not price. A limit order specifies a maximum buy price or minimum sell price, guaranteeing price but not execution. These are the two fundamental order types in stock trading.
Maximum Drawdown
Maximum drawdown (MDD) measures the largest peak-to-trough decline in an investment's value before a new peak is reached. It quantifies the worst-case loss an investor would have experienced and is a critical metric for assessing downside risk and emotional tolerance.
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Disclaimer: The information on this page is provided for educational and informational purposes only and does not constitute investment advice. AI-generated analysis may contain errors or inaccuracies. Always conduct your own research and consult a qualified financial advisor before making investment decisions.
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