This is not investment advice. The information provided is for educational and informational purposes only and does not constitute a recommendation to buy or sell any financial product.
A stop loss order is an instruction to the broker to sell a stock automatically if the price falls to a defined level. The order sits in the market and is triggered by the price, not by the trader's discretion. The trader who sets the stop before the trade is placed is the trader who honours the stop when the price reaches it. The trader who sets the stop after the trade is placed usually moves the stop, which is the most common way retail traders lose more than planned.
The mechanics
The trader places the order with a stop price and, usually, a limit price. The stop price is the trigger: when the market price reaches the stop price, the order is activated. The limit price is the maximum price the trader is willing to accept on the sale. The gap between the stop price and the limit price is the trader's protection against a bad fill in a fast market.
For a long position, the stop price is below the current market price, and the order is a sell stop. For a short position, the stop price is above the current market price, and the order is a buy stop. The mechanics are the same in both directions, with the side of the order reversed.
A stop loss order is not a guarantee. In a fast market, the price can gap through the stop price and the order can be filled at a much worse level than the trader expected. The limit price caps the maximum fill price, but the fill can still be far from the stop price. The trader who places a stop loss order in a fast market is taking the risk of slippage, and the slippage can be large.
Where to set the stop
The stop price is a function of the trader's strategy and the trader's risk tolerance. A common rule is to set the stop at a level that, if hit, produces a 1% loss on the account. The position size is calculated to produce that dollar loss at the stop, and the stop is set at the price level that produces the dollar loss. The position size and the stop are two sides of the same calculation.
A second rule is to set the stop at a level that is meaningful in the price structure of the underlying. A stop just below a recent support level is a structural stop, and the level is more likely to be respected by the market. A stop at a round number (like 5% below the entry) is a level that is more likely to be tested by short-term volatility, and the trader is more likely to be stopped out at the worst moment.
A third rule is to set the stop at a level that is consistent with the trader's timeframe. A trader with a multi-day view can set a wider stop, because the trader is expecting the price to move in the trader's favour over days, not hours. A trader with a same-day view should set a tighter stop, because the trader is expecting the price to move in the trader's favour over hours, not days.
Trailing stops
A trailing stop is a stop loss order that moves with the price. The trader sets the trailing distance (in absolute price or in percentage), and the stop moves to maintain the distance as the price moves in the trader's favour. The stop does not move when the price moves against the trader. The result is an order that locks in profits as the price moves in the trader's favour, while still protecting against a reversal.
A trailing stop is appropriate for a position that the trader wants to hold for an extended period, with the protection of a stop. The trailing distance should be wide enough to avoid being stopped out by normal volatility, and narrow enough to protect the gains. A common rule is to set the trailing distance at 2× to 3× the average daily range of the underlying.
Guaranteed stop loss orders
A guaranteed stop loss order is a stop loss order that the broker guarantees to fill at the stop price, with no slippage. The guarantee is a feature the broker offers for an additional fee, usually a small percentage of the position size. The fee is the cost of the guarantee, and the guarantee is most useful in a fast market where slippage is likely.
A guaranteed stop loss order is not available on all instruments or at all brokers. It is most commonly available on FX and CFD products, where the broker is the counterparty and the guarantee is a contractual commitment. It is less commonly available on exchange-traded stocks, where the broker routes the order to a lit exchange and cannot guarantee the fill price.
The trap of moving the stop
The most common mistake with a stop loss order is moving it. The trader sets the stop at a level that is consistent with the strategy, the price approaches the stop, the trader moves the stop to give the trade "more room," and the price continues to move against the trader. The trader eventually closes the position at a much worse level than the original stop would have produced, and the loss is much larger than planned.
The fix is to set the stop before the trade is placed, to honour the stop when the price reaches it, and to evaluate the strategy after the trade is closed. The trader who moves the stop is not trading a strategy. The trader is reacting to the market, and the reaction is the source of the loss.
Related resources
Where to start
If you are placing a stop loss order for the first time, the most useful exercise is to set the stop at the level that produces a 1% loss on the account, and to honour it. Our broker comparison lists the order types available at each broker, which together tell you what kind of stop loss order is supported and whether a guaranteed stop is on the table.