What is a Protective Stop?
A protective stop is a stop-loss order put in place to guard against losses beyond a specific threshold.
How Does a Protective Stop Work?
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 Does a Protective Stop Matter?
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.