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Traders are often told conflicting things about stop-loss orders. Some say you should always use them, while others say you should never use them.
So, what is it? Should you always use a stop-loss or never use one?
The real answer is that it depends.
Let’s discuss the different scenarios where you should consider using one and where you shouldn’t. We will also look at the pros and cons of using stop-loss orders.
What is a Stop-Loss order?
A stop-loss is an order type intended to limit a trader’s loss on a position. The order is placed at a price point at which the trader wants to cut their losses.
You can set a stop-loss order at a certain percentage or dollar amount below the price at which you purchased the security.
If the price falls and reaches the level you have set it at, the order will sell your position as a market order. This can cause slippage. Slippage means your order can get filled at a better or worse price than you have set it.
There is also a stop-limit order, which gives the trader control over the exact price he wants to sell at. Limit orders are not guaranteed to execute and can cause worse losses if the price falls dramatically.
See our other post about all the stock market order types to learn more.
When You Should Use One
It is common for day traders and swing traders to use stop-loss orders. Long-term investors rarely use them because they typically plan to buy more or hold if the price falls.
For short-term traders, a stop-loss can prove to be a very valuable tool. You can set clear risk management rules before entering a trade and use a stop-loss to stick with them.
A stop-loss can help traders preserve their capital and exit unfavorable trades. You should consider using them on almost every trade to keep your losses manageable.
When You Shouldn’t Use One
If you plan to hold the position for several years or more, it’s best not to use a stop-loss. Long-term investors should tolerate wide swings in price and continue to hold.
If you are bullish on a stock, you should want to buy more if it gets cheaper and not sell.
Experienced traders that are trading highly volatile securities may not want to use a stop-loss. The price swings can hit their loss and then resolve in a favorable direction.
Trading without a stop-loss requires experience and the ability to actively manage trades.
Pros of Using a Stop-Loss Order
- Can be used to limit losses and lock in profits.
- You can set it and forget it–which means less time is required to monitor your position.
- It prevents traders from making decisions based on emotions.
- Stops you from bag holding losses that destroy capital. (Also keeps you from missing out on better trades).
Cons of Using a Stop-Loss Order
- Your stop is not guaranteed to execute at the price level you have set. This can cause more considerable losses than anticipated.
- Stop-hunting is common. The price can move to take out stops then continue in a favorable trend.
- If used improperly, a stop-loss will only lock in losses. Traders that set a stop that is too wide or too narrow will continually end up with losing trades.
The concept of a stop-loss is very simple, yet using one effectively can be complex. The ultimate factor that determines your success with stop-loss orders is where you decide to set them.
Finding the correct place to put a stop requires experience with technical analysis and even fundamental analysis.
Whether you should use a stop-loss or not comes down to what security you are trading, your trading plan, and your experience level. Overall, it is wiser to use a stop-loss than not to use one in most trading scenarios.