What Is a Stop-Loss Order? (& When to Avoid It)

It can be difficult to know whether you're buying or selling a stock at just the right time. A stop-loss order can help mitigate the risk in certain scenarios, but it's not always the best bet.

Here's an explanation of what a stop-loss order is, plus when you should—and shouldn't—use it.

What are stop-loss orders in trading apps?

Not all brokerages or trading apps utilize stop-loss orders, but many do, so it's important to familiarize yourself with the term.

A stop-loss order is one of three types of trades you can make in investing (the other two are market and limit orders). Different markets have different names for this; the Dubai market in the UAE calls it a stop order.

When you buy or sell a stock with a stop-loss order, you set a stop price that's above or below the stock's current value. This can help prevent overpayment when purchasing a stock, or it can help you avoid holding onto a stock when it hits a certain percentage below your cost basis.

How stop-loss orders work

Like the name suggests, a stop-loss order works by stopping your losses by a specified amount.

A sell stop order occurs when an investor sets a stop price they don't want the stock to fall below. For example, you may purchase a stock and simultaneously set a 10% stop-loss order, so the brokerage will automatically sell your position if the value goes that low.

A buy stop order occurs when an investor sets a stop price they don't want the stock to exceed. Stock market values can move quickly. For example, an investor may set a stop price of 10% above the market value to avoid buying an overvalued stock.

When to use a stop-loss order

If you're taking part in short-term investing and want to change your positions frequently, a stop-loss order can come in handy and keep your portfolio from tanking.

Emotions can cloud short-term investment plans. If you feel like you might have trouble sticking to your strategy, a stop-loss order could be useful for you.

Stop losses are not just a way to prevent losses; they can also ensure capital gains.

If you're going on vacation, you can use a stop-loss order to keep your short-term investments in check without having to check up on them all the time.

Should you always use stop-loss orders?

Short answer: No.

Long answer: Investors can catch serious gains amid even the most wild volatility. As the saying goes, it's about your time in the market, not timing the market.

If a stock is experiencing short-term volatility, that activity could set your stop-loss order off. This selloff could eliminate your chances of capitalizing on the next bull run. For buy-and-hold investors, stop losses aren't necessary. It's also not a good idea for folks who believe in a stock's long-term potential.