A sell stop order is traditionally used as a way to exit an existing long position in the event that the share price were to decline. These types of orders are an excellent way to minimize losses in your investment portfolio, and reduce risk.
In general, a stop order is an order placed with your broker to purchase or sell a security when a preset price has been reached. Upon your specified price being met, your stop order will become a market order, meaning that it will be executed at the next available market price.
There are many uses for a sell stop order, including minimizing potential losses and protecting profits on an open long position, as well as initiating a new short position. These orders also act as an insurance policy of sorts in your portfolio, protecting you from sudden market swings, and assisting you in sticking with your trading plan as trades are executed automatically based on your preset criteria.
Using A Sell Stop Order To Reduce Loss and Protect Profits On An Existing Long Position
The most common use for a sell stop order is to protect your portfolio from losses due to declining share prices. When you have initiated a new long position, you can place your sell stop order below your purchase price. If the price of the security falls to your preset level, your sell stop order will become a market order, and will be filled at the next available market price.
If you have an existing long position on a security and have unrealized gains, you may wish to use a sell stop order to protect your potential profits in the event of a decline in share prices. You can adjust an existing sell stop order price to protect unrealized profits on your position.
While these tools can be useful in automating your investments, and protecting against sudden market swings, they are not optimal for every security or investment strategy. If your trading plan calls for frequent trading, or you are investing in particularly volatile securities, extreme price swings may inadvertently trigger your sell stop order, causing you to prematurely exit a position.
Using A Sell Stop Order To Enter Into A Short Position
When entering into a new short position, you may want to consider using a sell stop order. If you have concluded that a security may be moving lower in the future, you can enter your sell stop order to initiate your short position.
When using this strategy, you would enter a sell stop order at a price that is lower than what the security is trading at. If the specified security falls to your preset price, your order will be executed automatically. This gives you the advantage or not having to monitor the security constantly to see if it is declining in price.
A sell stop order can be an excellent tool to catch unexpected moves against your position in the market, or to utilize research that you may have done during hours when the market is typically closed. While sell stop orders can be great investment tools, there are also drawbacks to consider, you be sure to research every potential position carefully prior to committing any capital.