Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Protective Stop

What it is:

A protective stop is a stop-loss order put in place to guard against losses beyond a specific threshold.

How it works (Example):

Investors often have an idea of how much of their investment they're willing to lose. A protective stop ensures that a security will only lose up to a certain, predetermined amount. 

For example, assume an investor buys 1,000 shares of XYZ stock at $10 per share. He decides that he cannot afford for his shares to fall below a total value of $9,000 ($9 per share), so he sets a protective stop with a stop-loss order that tells his broker to automatically sell off his position as soon as the price hits $9.

Why it Matters:

Even though stop-loss orders offer crucial trading discipline to investors by helping them make important decisions about cutting losses, they also increase the risk of getting out of a position too early -- especially when volatile stocks are involved. In our example, if XYZ was known to be volatile and eventually rebounded from $9 to $12.50, then the investor would have missed out on the price appreciation.