What it is:
How it works (Example):
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.