Stop Loss Order Fundamentals
Stop loss orders are used to alleviate the losses that may be incurred if the price of your stocks falls under the desired level.
In order to minimize the potential losses from a falling price, under this type of order the broker is required to sell the stock when the level is hit.
A certain price level is specified in the stop loss order. The stop loss order turns into a market order when this price level is hit. Then the broker is required to execute a sale of the stock. In such a way the losses a minimized since the most beneficial price at that point is used to sell the stock.
The setting of the price level within the stop loss order is done with consideration of the current price of the stock. For example, if a stock is currently traded at $40, the stop loss value may be $35.
When deciding on the stop loss price, investors should make considerations about the future actions of the company that has issued the stock. Predictions on the influence of a potential breakthrough in the particular industry or withdrawal of the stock from the market should be made so that the drop of the price is made more reasonable.
For instance, if company X decides to withdraw one of its products from the market a decrease in the stock price will be experienced. As a result the value of the company will also drop.
After an announcement is made about the withdrawal of the product from the market, the price will start falling. As an owner of stocks from this company you should insure yourself with a stop loss order. After the stop loss price is hit, your order will transform into a market order. Your broker will be required to immediately sell the stock and hence minimize your losses.
Since the stock market is characterized with a very dynamic nature, the price you have set in your stop loss order may be ignored because your broker needs time to complete the trade. However, you will get the best price at the time of the trade.
Some investors even use stop loss orders to lock their profits.
Important Issues to Remember
You should be very careful when you set the price in your stop loss order. Since fluctuations in stock prices are a normal thing you should consider the reasonable range within which the stock's price may fluctuate. This is required in order to avoid selling the stock too soon. A stop loss price too close to the 3-5 points range may trigger a sale which is not required. The decrease in the price may be part of the normal fluctuations.
A benefit of stop loss orders is that they take the emotions element out of sell decision.
Additionally, stop loss orders may serve as insurance while you are away and cannot take care of your stocks. In this way you leave your stocks attended and ensure that you will not sustain great losses.
However, you should not think that stop loss orders give you a 100% guarantee against losses. Major events can take place at a high speed. Under such circumstances you should hope that you will sell the stock at a price that best approximates the desired level.
Stop loss orders should be used in order to protect you against large losses. You should consider their use whenever you plan not to hold a stock forever.
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