Stop-Loss and Limit Sell Order Explained

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Financial markets are not always moving upwards in a straight line. In the long history of financial markets, there have been many periods with highly volatile prices like during the burst of the dot-com bubble (around 2000) and at the beginning of 2020 when Corona started to become a global pandemic. The good news is: Investors are able to prevent losses by setting up stop-loss sell orders. There is even a way for making cash at rising prices by placing limit sell orders. In this article, you will learn how to limit the downside potential of your securites and how to make cash at a certain pre-defined price level.
Stop Loss and Limit Sell Order Explained Header

The Stop-Loss Sell Order

Stop Loss Sell Order Explained
Illustration 1: Stop-loss sell order
Imagine you have started to invest into the stock market years ago when we all were totally unaware of the upcoming pandemic – the next black swan event for stock market investors. The S&P 500 climbed from one all-time high to another until the virus appeared on headlines in global media coverage. Today, everyone knows that Corona led to a massive price drop at global market indices by the beginning of 2020. For example, the S&P 500 dropped by more than -30 % which was dramatic for investors that were new to the stock market. In this situation, it would have been a good idea to prevent losses by setting stop-loss sell orders. A stop-loss sell order helps you to get out of the market before reaching the absolute price bottom during a crisis.
Our illustration above will help you to get a better understanding of the concept. We assume a buy order at Day 1 whereby the purchase price of the security is USD 109.00. The investor decides to limit losses by setting a stop-loss sell order at USD 106.00. In this scenario, after an initial price gain at Day 2, the price drops to the stop-loss sell price of USD 106.00 at Day 7 and the investor gets out of the market with a realized loss of -2,75 %. This illustration also shows up potential disadvantages of the concept as after Day 7, when the investor already made its sell order, the market turns from bearish to bullish. In this case, the stop-loss sell order was not favourable for the investor as the security has been sold at the lowest price during the whole period.
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The Limit Sell Order

Limit Sell Order Explained
Illustration 2: Limit sell order
The limit sell order is a great way to set a minimum price for selling a security whereby the limit sell price is higher than the current price. In our scenario, with a purchase price of USD 109.00, the investor intends to realise profits at a limit price of USD 112.00. The positive price trend after Day 7 leads to a sharp stock price increase, whereby the stock price hits the limit sell price of USD 112.00 at Day 9. Thanks to the limit sell price order, the investor will make a profit at this day with a price gain of USD 3.00 (or +2.75 %). Nevertheless, even after Day 9 the positive price trend continues and the investor is going to miss out further price gains. But market timing does not always work – nobody knows when to get the best buy or sell price.

Criticism

In theory, you might expect that you will not lose more than the difference between purchase price and stop-loss sell price when setting a stop-loss sell order. But stock exchanges do not trade 24 hours per day and 7 days per week which is one major limitation of the stop-loss sell order concept. If the investor sets a stop-loss sell order at a price of USD 106.00 in our above scenario, but the market opens below this price (e.g. USD 104.00) at Day 7, the placed order will nevertheless sell the security at the lower (open) price. Furthermore, setting stop-loss sell orders especially for highly volatile securites could be a bad idea as high volatility makes is more likely to realize the expected loss in a short-time.

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