What it is:
How it works (Example):
For example, let's assume that you own 100 shares of Company XYZ stock, for which you have paid $10 per share. You are expecting the stock to hit $12 sometime in the next month, but you do not want to take a huge loss if the market turns the other way.
You direct your broker to set a stop order at $8.50. If the stock goes up, you will realize all of the benefits. If the stock goes down and touches $8.50, your broker will automatically place a market order to sell your shares.
It is important to note that when the stop order is triggered, it becomes a market order. You will not necessarily receive $8.50 per share; you will most likely receive a little more or a little less.
Why it Matters:
Stop orders generally are a trading or short-term investing strategy. They are useful because they help reduce the pressure of monitoring your trade day-to-day; the trade is largely set on autopilot. This can be particularly helpful for emotional investors.
Even though stop 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 fluctuated from $8.00 to $12.50 during the one-month forecasting period, then you would miss out on the price appreciation that you expected.
Long-term buy-and-hold investors probably don’t want to make substantial use of stop orders. When a stock goes lower, stop orders will lock in losses rather than give you a chance to evaluate whether a slight price decline is actually signaling a buying opportunity.