If you’ve ever watched the stock market dip and wished you had sold before the drop, you’re not alone. One tool that investors use to help manage risk is something called a stop-loss order. It’s a simple concept, but like most tools in personal finance and investing, it’s only powerful if you understand how and when to use it.
Let’s break down what stop-loss orders are, how they work, and whether or not they should be a part of your investing strategy.
A Simple Definition of a Stop-Loss Order
A stop-loss order is a type of order you give your brokerage to sell a stock if it falls to a certain price. It’s a way to try to limit your losses without having to monitor the stock constantly.
Let’s say you own shares of a company currently trading at $100. You’re okay with minor ups and downs, but you don’t want to lose more than 10%. You could set a stop-loss order at $90. If the stock falls to that price, your brokerage will automatically sell it—hopefully preventing a bigger loss.
Why Investors Use Stop-Loss Orders
There are several reasons why someone might use a stop-loss order:
- Limit downside risk: Stop-loss orders can help protect your portfolio from large, unexpected losses.
- Remove emotion from investing: It’s easy to panic during market downturns or hold onto a stock too long out of hope. A stop-loss automates the decision.
- Hands-off protection: If you’re not watching the markets every day (which most people shouldn’t be), a stop-loss gives you some peace of mind.
Types of Stop-Loss Orders
There are a few variations of stop-loss orders, and understanding the differences is important.
Stop-Loss Market Order
This is the most common version. You set a trigger price, and once your stock hits it, the order becomes a market order—meaning it will sell at the next available price. This is fast and usually effective, but in a rapidly falling market, your stock might sell for less than your stop price.
Stop-Loss Limit Order
In this case, you set both a stop price and a limit price. When the stock hits the stop price, it becomes a limit order, which will only sell at or above the limit price you’ve set. This gives you more control over the price, but there’s a risk: if the stock drops quickly past your limit price, your order might not execute at all.
Do Stop-Loss Orders Work in a Market Crash?
Stop-loss orders can help in normal market conditions, but during a crash or a sharp drop (like the flash crash of 2010), prices can fall so fast that your order might fill far below your stop price.
If you’re investing in volatile stocks or you’re worried about a sudden downturn, a trailing stop might be better.
What Is a Trailing Stop?
A trailing stop adjusts automatically as your stock rises. Instead of setting a specific price, you set a percentage or dollar amount below the current market price. If the stock climbs, your stop price climbs with it. If the stock falls, the stop price stays the same. Once the stock drops to your trailing stop price, it sells.
This is useful for locking in gains while still giving your investment room to grow.
Should Long-Term Investors Use Stop-Loss Orders?
If you’re following a long-term, buy-and-hold strategy, especially one that focuses on broad index funds like the S&P 500, you might not need stop-loss orders at all. Selling during downturns can interrupt compounding growth. In fact, stop-losses can sometimes trigger a sale right before a stock bounces back.
That said, if you’re investing in individual stocks or want a safety net for short-term trades, stop-loss orders can be useful.
Stop-Loss Orders vs. Financial Planning
While stop-loss orders can help reduce losses, they’re not a substitute for a strong financial plan. Tools like budgeting apps, a solid emergency fund, and a diversified portfolio matter more in the long run. Learning to manage your emotions and sticking to a simple plan, like investing regularly in a low-cost S&P 500 fund, often outperforms short-term trading strategies.
Final Thoughts
Stop-loss orders are a practical tool for protecting your investments from large drops, but like all tools, they need to be used wisely. They’re not for everyone, and they don’t guarantee profits or prevent all losses. Still, understanding how they work puts you one step closer to becoming a smarter, more confident investor.
If you’re serious about learning how money works, consider picking up a few of the top books on money, track your spending with a budgeting app, and invest with a long-term mindset. With the right habits, tools like stop-loss orders become a supplement (not a crutch) to a strong financial life.
Winchell House 
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