How a stop-loss order can help protect your profits
Prudent trading means having the discipline to know when to crystallise your losses and when to realise your gains.
A stop-loss order can help here. It's simply an instruction to your broker to sell a security once it falls to a pre-determined price.
The most common way of doing this is by assigning a percentage threshold to the purchase price of the security. This could be, say, 20% below the price at which you bought the security. In other words, once a stock falls to 80% of the price you bought it, the broker will automatically liquidate the position. The idea here is to prevent further losses.
Another way is by utilising a trailing stop, where the sell order is set at a percentage level below the market value of a security. Trailing stops can only move up in price, never down. So if the market moves up, the trail stop will move up with it. However if the market turns down, the trailing stop will not lower. The trailing stop, while minimising losses, is more designed to lock in gains made.
There are some drawbacks to stop-loss orders. Brokers charge fees for these orders, and it isn't guaranteed that they'll sell the security at the arranged price. While stop-loss orders are meant to be executed at the next available price, this could be significantly lower than the arranged percentage level.
This could be due to a range of factors, such an aftermarket announcement that results in the stock opening below the sell order price.
This can be managed with a stop-limit price, which is the lowest price you're willing to sell the security. In this case, the stock will only be sold once its price lifts above the stop-limit price. Of course, there's the risk the market doesn't rebound above the stop-limit price, in which case you'll be left holding a stock while its market value plummets.