What Is a Stop-Loss Order?
A stop-loss order is a type of conditional order that sits dormant until a specified price level is reached, at which point it becomes active and attempts to close a position. For a long position (one where you have bought a security hoping it will rise), a stop-loss is set below the current price. If the price falls to the stop level, the order triggers and the position is sold.
The name reflects its purpose: to stop a loss from growing beyond a predetermined amount. A trader who buys a stock at $60 and sets a stop-loss at $55 has defined their maximum loss on that trade as $5 per share (plus any execution costs), assuming the order fills at or near the stop price.
Stop-loss orders are distinct from limit orders (which specify a price at which to buy or sell) and market orders (which execute immediately at the best available price). A stop-loss is a trigger — when the price reaches the stop level, a secondary order (either a market order or a limit order, depending on the type) is sent to the exchange.
Stop-Market vs Stop-Limit Orders
There are two main variants of stop-loss orders, and understanding the difference is important for managing execution risk.
A stop-market order triggers a market order when the stop price is reached. This means the position will be closed at the next available market price, which in normal conditions is very close to the stop price. The advantage is certainty of execution — the position will be closed. The disadvantage is that in fast-moving markets or thinly traded securities, the actual execution price may be significantly worse than the stop price.
A stop-limit order triggers a limit order when the stop price is reached. You specify two prices: the stop price (which activates the order) and the limit price (the worst price at which you are willing to transact). The advantage is that you will not sell below your limit price. The disadvantage is that if the market moves through your limit price very quickly — for example, in a fast gap down — the order may not fill at all, leaving you in a position with an unrealised loss that continues to grow.
Neither type is universally superior. The choice depends on the liquidity of the security, the urgency of the exit, and the trader's tolerance for the two types of risk — execution risk (stop-limit may not fill) vs price risk (stop-market may fill far from the stop price).
Common Approaches to Stop-Loss Placement
Where to place a stop-loss is a question of trade structure rather than a universal rule. Different traders and strategies use different approaches, each with its own logic.
Support-based stops are placed just below a price level that has previously acted as support — a level where buyers historically stepped in and the price bounced upward. The reasoning is that if price breaks convincingly below this level, the original thesis for the trade may no longer be valid.
Volatility-based stops use a measure of the security's typical daily price movement — often the Average True Range (ATR) — to set a stop distance that accounts for normal fluctuations. A stop set at 1.5× ATR below the entry gives the trade room to breathe within normal volatility while still defining a maximum loss.
Fixed percentage stops are simply placed a set percentage below the entry price — for example, 5% or 8%. This approach is easy to calculate but does not account for the specific characteristics of the security or its recent price behaviour.
Stop-Loss Orders and Gap Risk
A stop-loss order provides meaningful protection against gradual price declines during regular trading hours. It provides much less protection against sudden large price gaps — situations where a stock opens substantially higher or lower than the previous day's close without trading at intermediate prices.
Gap risk is most significant around earnings announcements (which most US companies release outside regular trading hours), major economic data releases, and unexpected news events. A company that closes at $80 and reports disappointing earnings after the close might open the following morning at $55. A stop-loss set at $75 would trigger at the open and execute at approximately $55, not $75.
This is not a flaw in the stop-loss mechanism — it is a fundamental characteristic of how markets work. Traders who need tighter control over gap risk in individual positions sometimes use options strategies or reduce position size before known risk events such as earnings. These approaches have their own costs and complexities.
The Psychology of Stop-Loss Orders
One of the most commonly discussed aspects of stop-loss orders in trading education is the psychological challenge of adhering to them. It is natural to feel reluctant to close a losing position — to hope the price will recover, to feel that selling at a loss makes the loss 'real.'
This reluctance is sometimes described as loss aversion — the tendency (well-documented in behavioural economics research) for people to feel losses more acutely than equivalent gains. A $1,000 loss feels worse than a $1,000 gain feels good, even though they are the same amount.
Submitting a stop-loss order in advance — before the trade is placed or immediately after — removes the in-the-moment decision about whether to exit. The exit level is decided when the mind is calm and the plan is clear, rather than in the midst of watching a loss grow.
This educational content is provided for informational purposes only. It does not constitute financial or investment advice. All trading and investing involves substantial risk of loss. Always conduct your own research and due diligence, and consider consulting a qualified financial professional before making any investment decisions.