Key Takeaways
- Stop-loss orders automatically close a position when price reaches a preset level to limit losses.
- Use stop types (market stop, stop-limit, trailing stop) to match your trade plan and market liquidity.
- Set stops based on volatility, technical support/resistance, or a fixed percentage, combine methods for better results.
- Position sizing and a maximum dollar risk per trade make stops effective risk-management tools.
- Avoid common mistakes: placing stops too tight, moving stops impulsively, and ignoring slippage/fees.
Introduction
A stop-loss order is an instruction to sell (or buy to cover) a security when its price reaches a level you specify. It’s one of the simplest and most powerful tools traders use to limit losses and control risk.
For new investors, understanding how stops work and when to use them matters because unmanaged losses can quickly erode a portfolio. Stops help enforce discipline, reduce emotional decision-making, and protect capital so you can trade another day.
This article covers what stop-loss and trailing stop orders are, how to choose appropriate stop levels using practical methods, examples using real tickers like $AAPL and $TSLA, common mistakes to avoid, and clear next steps you can use today.
What Is a Stop-Loss Order?
A stop-loss order is an instruction to your broker to sell a position once the market reaches a specified price (the stop price). It’s designed to close a losing trade before losses grow larger than you’re willing to accept.
There are two common variations: a stop market order (which becomes a market order when triggered) and a stop-limit order (which becomes a limit order when triggered). Each has pros and cons related to execution certainty and price certainty.
Stop Market vs. Stop-Limit
A stop market order prioritizes execution: the order will fill once the stop price is hit, but the fill price can differ from the stop price in fast-moving markets (slippage).
A stop-limit order prioritizes price: when the stop price triggers, the order becomes a limit order at the limit price you set. It may not fill if the market moves through your limit, leaving you still exposed.
Types of Stop Orders and When to Use Them
Understanding the different stop types helps you choose the best one for your situation and market conditions. The three common types are stop market, stop-limit, and trailing stop.
Stop Market Order
Stops to market are simple and reliable for execution. Use them when you prioritize closing the position quickly, such as in thinly traded securities or during large gaps.
Stop-Limit Order
Stop-limit orders give price control, which matters if you can’t accept fills below (or above) a given price. Use them when liquidity is low and you’re willing to stay in the trade rather than accept a worse price.
Trailing Stop
A trailing stop follows the market price at a set distance (percentage or dollar amount). It locks in gains as the price moves in your favor while still providing a stop when the trend reverses.
For example, a 5% trailing stop on an entry at $100 moves up as the price rises: if the stock reaches $120, the trailing stop would sit at $114 (5% below $120).
How to Set Appropriate Stop Levels
Choosing where to place a stop is a balance between giving the trade room to breathe and protecting capital. Use a method that fits your trading timeframe and the security’s volatility.
1) Percentage-Based Stops
A simple method is a fixed percentage from your entry, such as 2% for short-term trades or 10% for longer-term swing trades. This method is easy to apply and pairs well with a consistent position-sizing rule.
Example: If you buy $AAPL at $150 and use a 5% stop, your stop price is $142.50. If your account rule is to risk $200 per trade, you’d size the position so that a move from $150 to $142.50 equals $200 risk.
2) Volatility-Based Stops (ATR)
The average true range (ATR) measures recent price volatility. Multiples of ATR (e.g., 1.5× ATR) can set stops that adapt to how choppy or calm a stock is.
Example: $TSLA has a 10-day ATR of $8. If you set a 2× ATR stop on a $250 entry, the stop would be $250 - (2×$8) = $234. This gives more room during volatile periods and tightens when the stock calms.
3) Technical Stops (Support & Resistance)
Place stops just beyond technical levels like recent swing lows, moving averages, or trendlines. This aligns your stop with market structure rather than an arbitrary percentage.
Example: If $MSFT has a recent support level at $300 and you enter at $320, you might place a stop slightly below $300 (e.g., $297) to avoid getting stopped by normal noise while still protecting capital.
4) Time-Based Stops
For short-term trades, use time stops: exit if a trade hasn’t moved as expected within a set timeframe. This prevents capital from being tied up waiting indefinitely for results.
Position Size and Risk Per Trade
Stops are effective only when combined with sensible position sizing. Decide how much you’re willing to lose on any trade (e.g., 1% of account equity) and calculate position size from your stop distance.
- Determine max dollar risk (account size × risk percent).
- Calculate stop distance (entry price − stop price).
- Position size = max dollar risk ÷ stop distance.
Example: With a $10,000 account and 1% risk ($100), a stop distance of $5 implies a position of 20 shares ($100 ÷ $5 = 20 shares).
Placing Stops in Different Trading Scenarios
Stops should be tailored to your trading style. A day trader’s stop approach differs from a buy-and-hold investor’s strategy.
Scalping and Day Trading
Shorter timeframes require tighter stops, often measured in ticks or cents, but these trades usually use smaller position sizes to keep dollar risk manageable. Execution and low slippage are critical.
Example: A day trader buying $SPY at $420 might use a $0.30 stop to limit losses, but will size the position so that the $0.30 move equals their target risk (e.g., $50).
Swing Trading
Swing traders use wider stops that accommodate overnight movement and short-term volatility. ATR and technical stops are common here.
Example: A swing trader buys $AMZN at $110 and sets a stop 7% below entry or below the 20-day moving average, whichever is wider.
Long-Term Investing
Long-term investors may use mental stops or very wide mechanical stops tied to fundamentals. Frequent stop placement isn’t always appropriate for long-term positions, but a plan for maximum drawdown helps.
Real-World Examples: Stops in Action
Example 1, Trailing Stop Locks in Gains: You buy $AAPL at $150 and set a 6% trailing stop. If $AAPL rises to $180, the trailing stop moves to $169.20. If the price then falls 6%, the trailing stop triggers and you exit, preserving a substantial portion of the gain.
Example 2, Volatility-Based Stop for a Swing Trade: You buy $TSLA at $250. The 10-day ATR is $10, and you use 2× ATR ($20) as your stop distance. Your stop sits at $230, giving room for $TSLA’s typical swings while limiting losses if the trend fails.
Example 3, Technical Stop Meets Position Sizing: You buy $MSFT at $320 with support at $300. You set a stop at $297 and calculate shares so that the $23 risk per share keeps your maximum loss at $200. This enforces risk control tied to market structure.
Common Mistakes to Avoid
- Placing stops too tight: A stop that’s inside normal price noise will trigger often (whipsaw). Use volatility or technical levels to give enough room.
- Moving stops impulsively: Bumping stops farther out after a trade turns against you increases risk. Instead, reassess the thesis or accept the planned loss.
- Ignoring slippage and fees: Real execution prices can differ from stops, especially in fast markets. Account for commissions and potential slippage in your plan.
- Using stop-limit orders without contingency: A stop-limit may fail to execute in a gap or fast move, leaving you exposed. Know the trade-off between execution certainty and price certainty.
- Not sizing positions: A stop without position-sizing rules can still allow outsized losses. Always calculate shares from your dollar risk limit.
FAQ
Q: How is a stop-loss different from a limit order?
A: A stop-loss triggers a market or limit order when the stop price is hit. A limit order executes only at a specified price or better. Stops protect against losses; limit orders control execution price for entries or exits.
Q: Will a stop-loss protect me from overnight gaps?
A: Stops can reduce risk but do not guarantee fill prices during gaps. A stop-market will execute at the next available price, which could be worse than the stop. Stop-limit may not fill at all if price gaps past the limit.
Q: Should I always use trailing stops when a trade is profitable?
A: Trailing stops are useful for locking gains, but the amount of trail should match volatility and your trade horizon. Use a trailing stop if you want to capture upside while defining an exit, but tailor the distance to avoid early takeouts.
Q: Can stop orders be visible to the market?
A: Most retail stop orders are not visible until triggered, but some types of conditional orders or broker routing can make them more detectable. In highly illiquid stocks, visible limit orders near key levels can affect supply and demand.
Bottom Line
Stop-loss orders are a foundational risk-management tool that protect capital and enforce trading discipline. Choosing the right stop type and level depends on your timeframe, the security’s volatility, and your personal risk tolerance.
Combine stops with clear position-sizing rules and a written trading plan. Practice setting stops with small positions or on paper trades until you’re comfortable with how they behave in live markets.
Next steps: pick one stop method (percentage, ATR, or technical), define a per-trade risk limit for your account, and apply both on a small real or simulated trade to see how stops perform in different market conditions.
