Stop loss — what it protects you from, and what it does not

What this is about

A stop loss is a standing instruction: if the price reaches a level I have set, sell. It is the most widely recommended risk tool for private investors and the most widely misunderstood, because of one specific gap between what people think it promises and what it actually does.

The mechanics

You hold a share bought at 100 and set a stop at 90.

Nothing happens while the price stays above 90. When the price touches or passes 90, the stop triggers, and what happens next depends on the type:

A stop market order becomes a market order the moment it triggers: sell at whatever the next available price is. It will almost certainly execute. The price you get is not promised.

A stop limit order becomes a limit order: sell, but not below a price you specify. The price is protected. Execution is not — if the market has moved past your limit, it sits unfilled and you are still holding.

That is the trade-off, and there is no version without it. You choose between "I will definitely be out, at an unknown price" and "I will get my price or stay in".

The gap nobody mentions

A stop is not a floor.

The stop sets where your order activates, not where you exit. When a share closes at 95 and opens the next morning at 70 on overnight news, a stop at 90 was never reachable — there were no trades between 95 and 70 for it to act on. It triggers on the open and sells around 70.

This is a gap, and gaps are not rare. Results, regulatory decisions, and news arriving while the exchange is shut all produce them. The single most common false belief about stop losses is that they cap your loss at the stop level. They cap it at the next available price, which on the days you most needed protection is exactly the price that has moved furthest.

Where to put it — and the mistake

The instinct is to set the stop where the loss becomes uncomfortable. Ten percent, say, because ten percent feels like enough.

That number is about you, not about the share. A share that routinely moves 4% a day will hit a 10% stop in the course of an ordinary week without anything having gone wrong. You will be sold out of a position for reasons that have nothing to do with your reason for holding it — and this happens often enough to have a name: getting stopped out.

The better question is how much room does this share need in order to behave normally, and only then whether you can afford that much room. That is where Position sizing comes in: if the stop has to be far away for the share to breathe, the position has to be smaller. Size and stop are one decision, not two.

Average True Range — a measure of how much a share typically moves in a day — is the usual tool for the first half of that question.

Trailing stops

A trailing stop follows the price up and never moves down. Buy at 100 with a 10% trail: the stop starts at 90, and if the price reaches 130 the stop has risen to 117 and stays there.

It converts an open profit into a protected one without requiring you to decide when to sell. It has the same gap risk as any other stop, and the same stopped-out risk if the trail is tighter than the share's normal movement.

What this does not tell you

It does not tell you a stop makes a position safe. It bounds the ordinary case and not the extreme one, and the extreme one is what damages a portfolio.

It does not tell you where the right level is. There is no correct percentage. Anybody offering one without asking what you own and how much of it is guessing.

It does not tell you stops improve returns. The evidence is mixed and depends heavily on the market, the period and the rule tested. A stop is a tool for controlling the size of a loss, not for making money. Adding one to a strategy that loses money slowly produces a strategy that loses money in a more controlled fashion.

It does not remove the decision. A stop that you move down when it is about to trigger is not a stop. It is a note to yourself that you did not act on, and moving it is the single most common way the tool fails in practice.

Where to see this in the app

Portfolio → place an order offers stop and stop-limit types, so the difference between "definitely out" and "out at my price" is a choice you make explicitly rather than discover afterwards.

Alerts is the lighter alternative and is often the better one while you are learning: it tells you the level was reached and leaves the decision to you.

Chart → the daily range over a few months answers the question this lesson says to ask first — how much does this share move on an ordinary day — before you choose a distance.

Orders shows anything armed and waiting, which is where to check that a stop you set weeks ago is still where you think it is.

Trading in this app is simulated. That makes it the right place to find out what being stopped out feels like, at no cost.