A stop loss is an order that closes a position automatically if the price reaches a level you chose in advance. It is the most common tool for limiting the loss on a single trade, and it is also one of the most misunderstood. A stop does not protect you from every loss. It can be skipped by a price gap, it can be triggered by a brief spike, and it can make you sell at the worst moment. This guide explains what a stop does, how to set one, and what to do about its limits.
What a stop does
A stop loss turns an open-ended loss into a limited one, at least in normal conditions. Suppose you buy a share at 50 and set a stop at 45. If the price falls to 45, the stop becomes an order to sell, and the position should close near that level. The most you expect to lose per share is about 5, plus costs.
The stop does not decide whether the trade is good. It only sets the point at which you accept being wrong. That is useful because most losing trades get worse as people hope they will recover, and a stop removes that decision from the moment of panic.
Types of stop
There are three common types.
- A fixed price stop closes the trade at a set price, such as 45 in the example above.
- A percentage stop sets the level as a fixed percentage below the entry. A 10 percent stop on a purchase at 50 would be at 45.
- A trailing stop moves up as the price rises, but never down. It locks in some profit while leaving room for the trade to run.
Each type suits a different plan. A fixed stop is easiest to plan with. A trailing stop protects gains, but a normal dip can close the trade before the trend resumes.
Where to put the stop
The most common mistake is placing the stop at a number that feels safe rather than one that is meaningful. A good stop goes at a point where your view of the trade is proven wrong. For example, if you bought because the price had bounced off a support level, a close well below that level is evidence that the reason for the trade no longer holds.
A stop placed too close will be hit by ordinary moves in the price, which traders call noise. A stop placed too far may lose more than you planned. Check the typical daily range of the share before you choose the level. If a share moves 4 percent on an ordinary day, a stop 1 percent below your entry will be hit by normal movement.
Sizing the trade around the stop
The stop tells you the risk per share. That is the information you need to size the position. Suppose you have 10,000 to trade and you decide to risk no more than 1 percent of it on one trade, which is 100. If your stop is 5 per share below the entry, you can hold 20 shares, because 20 times 5 is 100.
If the stop were 2 per share instead, you could hold 50 shares. The same risk limit gives a different position size depending on where the stop sits. This is why the stop and the size should be set together, before you place the order. The guide on position sizing basics goes through the method in more detail.
A worked example
Suppose you buy 100 shares at 50, so the position costs 5,000. You set a stop at 45. The risk per share is 5, so the total risk is 500, which is 10 percent of the position and 5 percent of a 10,000 account.
| Price | Position value (100 shares) | Result against the 5,000 cost |
|---|---|---|
| 50 (entry) | 5,000 | 0 |
| 47 | 4,700 | −300 |
| 45 (stop) | 4,500 | −500, trade closed |
| 42 (gap through the stop) | 4,200 | −800, trade closed at the next available price |
The last row shows the main limit of a stop. If the price gaps down overnight, the first available trade may be at 42, below the stop. The loss is then larger than planned. Gaps are more common around news, in thin shares, and when markets are closed.
How stops fail
Gaps. The price jumps past the stop with no trades at the stop level. You exit at the next price, which can be far worse.
Spikes. A brief, sharp move hits the stop, and the price then recovers. The stop closes a trade that would have worked. This is common in thin markets and around the open.
Stops that are obvious. Many traders place stops at the same round numbers or just below the same support level. A sharp move can sweep through those clustered stops.
Stops that are moved. Moving a stop further away when the price falls defeats its purpose. It turns a planned loss into an unplanned one.
Stops that are not placed. An order that is not entered, or is cancelled, provides no protection. Check that the stop is live after you place it.
What to do about the limits
Accept that a stop limits losses rather than eliminating them. Size positions so that a gap through your stop would still be a loss you can bear. Use limit orders where the market allows them, so you know the price you could receive. Avoid holding through known events if the gap risk is too large for your account.
Do not move a stop to make a losing trade feel better. If you want a different stop, make that decision before you enter, and record it. The guide on trading psychology covers why moving stops is so common and how to stop doing it.
Mental stops and real stops
A mental stop is a level you intend to exit at, but do not place as an order. It feels flexible, and that is the problem. In a fast move, a mental stop is easy to ignore, and the trade keeps losing. A real stop is an order in the market, so it acts without a decision in the moment. Most traders who use stops for discipline use real orders, and they accept that a real order may fill at a worse price than the level they chose.
Common mistakes
No stop at all. A trade with no defined exit has an unlimited downside on paper, and that exposure grows as the position grows.
A stop that is too tight. Frequent small losses from noise can add up to more than one planned loss.
Treating the stop as a target. A stop is not a plan to sell at a particular price. It is the level at which you admit the trade is not working.
Averaging down past the stop. Adding to a losing position to lower the average price increases the risk you originally set, usually without a plan.
Key takeaways
A stop loss closes a trade at a chosen price to limit the loss. Set it at the point where your reason for the trade is proven wrong, not at a number that feels comfortable. Size the position from the stop, so that the loss at the stop is an amount you accept in advance. Know how stops fail, especially through gaps, and accept that a stop limits losses rather than removing them. Do not move the stop once the trade is open to avoid taking a loss.
This guide is for general information, not financial advice. See the disclaimer.