Stop-Loss Order
A stop-loss order automatically sells a stock when it drops to a specified price. It's a risk management tool that limits potential losses without requiring constant monitoring.
Formula
Example
You buy at $100 and set a 10% stop-loss at $90. If the stock drops to $90, it automatically sells. Your loss is capped at 10% (plus any gap risk).
How to Interpret It
Stop-losses protect against large losses but can trigger during normal volatility. A 7-10% stop on swing trades is common. For long-term holdings, wider stops (15-20%) or none at all may be better. Be aware of gap risk — the stock may open below your stop price. The key is matching your stop strategy to your trading style and the stock's volatility.
Stop-Loss Strategies Compared
| Strategy | How It Works | Best For | Typical Setting |
|---|---|---|---|
| Fixed % | Set X% below purchase price | Day/swing trades | 7-10% |
| Trailing % | Moves up with highest price | Trending stocks | 15-20% |
| ATR-Based | 1-2x Average True Range below | Volatile stocks | 1.5-2x ATR |
| Technical Level | Below support or moving avg | Position trades | Varies by chart |
Position Sizing with Stop-Losses
Professional traders use stop-losses to determine position size. The formula: Position Size = Risk Amount ÷ (Entry Price - Stop Price). For example, if you're willing to risk $500 (1% of a $50,000 account) and your entry is $100 with a stop at $93 ($7 risk per share): Position Size = $500 ÷ $7 = 71 shares ($7,100 position). This ensures you never lose more than your predetermined risk amount.
Gap Risk: The Stop-Loss Blind Spot
A standard stop-loss becomes a market order when triggered. If a stock closes at $50 and opens the next morning at $42 on bad earnings, your $45 stop triggers — but the sell executes at $42 or lower. You lose $8/share instead of the planned $5. This "gap risk" is unavoidable with regular stop orders. Stop-limit orders protect against bad fills but risk not executing at all if the stock gaps past your limit price.
Common Mistakes
- ❌ Setting stops too tight. A 3% stop on a stock that regularly swings 5% daily guarantees you'll be stopped out repeatedly. Research shows that trailing stops at 15-20% produce the best results for long-term momentum strategies (1.73% avg monthly return vs. 1.01% without stops in 54-year backtests).
- ❌ Moving stops down. "I'll just give it a little more room" is how small losses become big losses. Set your stop before entering and never move it further from your entry. Only trail stops in the direction of profit.
- ❌ Ignoring account-level risk management. Even with individual stop-losses, risking 10% of your account per trade across 5 positions means a 50% drawdown if all stops hit. Professional traders risk 1-2% per trade maximum.
- ❌ Using stops on highly volatile or low-volume stocks. Illiquid stocks can have violent intraday swings that trigger stops before reversing higher. ATR-based stops adapt to volatility better than fixed percentages for these situations.
💡 Pro Tip: The 2% Account Rule
Never risk more than 2% of your total account value on a single trade. On a $25,000 account, that's $500 max loss per trade. Combined with proper position sizing (risk ÷ stop distance = shares), this rule ensures you can survive a long losing streak. Even 10 consecutive losses only costs you 18% of your account — recoverable, not catastrophic.
Frequently Asked Questions
What percentage should my stop-loss be?
Common stop-loss levels: 7-8% for swing trading, 15-20% for long-term investing. The key is setting stops based on support levels and volatility, not arbitrary percentages. A 5% stop on a volatile tech stock will trigger constantly from normal fluctuations, while 5% on a utility stock may be appropriate.
What is a trailing stop-loss?
A trailing stop moves up with the stock price but never moves down. If you set a 10% trailing stop on a stock at $100, it triggers at $90. If the stock rises to $150, the stop moves to $135. This locks in profits while giving the stock room to grow. Most brokerages offer trailing stops as an order type.
Do professional investors use stop-losses?
Most don't. Value investors like Buffett argue that if you've done your research, price drops are buying opportunities, not sell signals. Stop-losses can force you to sell at the worst time — during market panics when prices are irrationally low. However, traders and quantitative strategies frequently use stops as risk management.