Stop losses and their failure modes

In short

I once watched a neighbor set a rule for his garden gate and then forget which latch he had picked. If you have ever placed a stop loss order and wondered what it really promises, you are in good company. A stop loss is an instruction to your broker to sell once a price is touched. It is not a promise of any particular sale price. When the trigger hits, the order can turn into a market order, and a market order takes whatever price the market offers. A stop limit order works differently, because it sets a floor, but it may not fill at all. Before you place either kind, read your broker's own page on order types. You care about protecting what you worked for, and that is a fine reason to learn this.

The whole of it

What it is

A friend of mine once asked me why his stop did not save him the way he pictured it would. He thought a stop was a wall. It is closer to a doorbell. When the price touches your trigger, the bell rings, and your broker sends a new order to the market.

A plain stop loss order is also called a stop market order. You pick a trigger price below where you bought. If the price falls to that trigger, your order becomes a market order to sell. A market order means sell now at the best price on offer. The trigger is only the moment the order wakes up. It is not the price you will get.

There is a cousin called the stop limit order. It has two prices. One is the trigger, and the other is the limit, which is the lowest price you will accept. It gives you control over price, but it gives up the promise of a sale. If the market skips past your limit, your shares stay unsold.

If you are curious where to read more, the SEC's investor education site, Investor.gov, has a plain page on stop orders and stop limit orders. FINRA also explains order types on its own site. Both are worth a quiet read.

How it works

If you are holding a stock you bought at 50 dollars, you might set a stop at 45 dollars. You are telling the broker, if it touches 45, get me out.

Here is the part that trips people up. Markets do not move smoothly. Prices jump from one trade to the next, and sometimes the jump is large. A stock can close at 46 dollars and open the next morning at 41 dollars after bad news. That is called a gap. Your stop at 45 dollars was passed over in the night. When the market opens, your order wakes up and sells at the first prices it can find, which is near 41 dollars. You got out, but not where you drew the line.

Stops also sit still while the market is closed. Whether a regular stop order is active outside regular trading hours depends on your broker, so check its rules on that. A fast drop during a busy moment can also cause slippage. That is the gap between the price you expected and the price you got. Thin trading makes it worse, because fewer buyers means each sale pushes the price down further.

The numbers, and where to find yours

A stop loss has no yearly limit set by law, so there is no official figure to look up. The numbers that matter are yours. They are your buy price, your trigger price, and how much you can afford to lose. You will also want to know your broker's commission on a sale.

If you hold the stock in a taxable account, a loss may matter at tax time. The wash sale rule can disallow a loss if you buy the same or a nearly identical security within the current figure, which the official source publishes each year days before or after the sale. The IRS explains this in Publication 550, Investment Income and Expenses. Your own tax situation may differ, and that page is the place to check it.

Your broker's order ticket will show the trigger and limit fields. Look at what it says about when the order is active. That small note tells you a lot.

A worked example

Let me tell you about a woman named Marisol, who lives in Ohio. She bought 100 shares of a company at 50 dollars each. Her cost was 100 times 50, which is 5,000 dollars. She wanted to keep her loss near 500 dollars, so she set a stop at 45 dollars.

Picture the stock sliding down gently and her order selling at 45 dollars. Her loss would be the 5 dollar drop on each of 100 shares. That is 100 times 5, which is 500 dollars. It would match her plan.

Then the company shared bad news after the market closed. The next morning the stock opened at 41 dollars. Her stop woke up and sold at the open. Her loss was 100 times 9, which is 900 dollars. The stop worked as designed. It just did not work as she pictured.

Now suppose she had used a stop limit with a trigger of 45 dollars and a limit of 44 dollars. The stock opened at 41 dollars, below her limit. Her order would not fill. She would still own the shares, and the price could keep falling or bounce back. She would have kept price control and lost the promise of a sale.

Neither choice is wrong. Each one trades one risk for another. Marisol saw how that trade works before her money was on the line, and that is a kind way to learn.

Where it goes wrong

I have seen good people get hurt by a tool they trusted a little too much. Here is where stops tend to fail.

Gaps come first. As Marisol found, the price can leap past your trigger. Slippage is next, since a fast market can hand you a worse price than you expected. Thin markets bring wide swings between trades.

A stop limit brings its own trouble. It may not fill, and you may not notice until the loss has grown.

Then there is the whipsaw. You set a stop too close to your buy price. Normal daily wiggles touch it, you are sold out, and then the price climbs right back. You paid a commission and locked in a small loss for nothing. A trigger that sits inside the normal daily swing can get hit by ordinary noise.

Stops can also be missed at the edges of the day. Read how your broker treats orders before the open, after the close, and during trading halts. A halt pauses trading in a stock, and no order can fill until it ends.

Last, a stop can give a false sense of safety. It feels like insurance. It is not insurance. It is only an instruction, and instructions can meet a market that does not follow along.

Questions to answer before you leave this page

If your stock gapped down overnight, could you live with a sale far below your trigger? Do you want a sale to be certain, or do you want the price to be certain, since a stop limit cannot promise both? Have you read your broker's page on when stop orders are active, including before the open and after the close? Is your trigger sitting inside the normal daily swing, where ordinary noise could knock you out? Do you know what a sale would cost you in commission, and how a loss would be treated at tax time under the wash sale rule described in IRS Publication 550? And when you look at your own plan, can you say in a sentence what the stop is there to do?