stop-loss [CapiPedia]

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====== Stop-Loss ======
A stop-loss order is an instruction you give your [[broker]] to sell a security when it drops to a specific price, known as the "stop price." Think of it as an automatic eject button designed to limit your losses on an investment. For instance, if you buy shares of a company at $100 each, you might place a stop-loss order at $90. Should the stock's price fall to $90, your broker will automatically trigger a sell order, hopefully getting you out before the price tumbles further. This tool is incredibly popular among short-term traders who want to enforce discipline and remove emotion from their selling decisions. It acts as a safety net, intended to prevent a small loss from snowballing into a catastrophic one. However, for the disciplined [[value investing|value investor]], this "safety net" can often look more like a trap.
===== The Value Investor's Dilemma with Stop-Losses =====
The core philosophy of value investing, championed by figures like [[Warren Buffett]], is fundamentally at odds with the concept of an automatic stop-loss. Why? Because a value investor buys a business, not just a flickering stock price. A price drop in a wonderful company is often seen as a golden opportunity to buy //more// at a discount, not a signal to run for the hills.
A stop-loss order makes a critical, and often flawed, assumption: that a falling price means your investment thesis is wrong. For a value investor, the decision to sell should be based on a change in the company’s fundamental [[intrinsic value]]—perhaps its [[competitive advantage]] is eroding, its management is failing, or its industry is in permanent decline. A stop-loss ignores all of this and sells based on //price alone//. It automates a decision that should be among the most carefully considered. As Buffett advises, investors should be "fearful when others are greedy, and greedy when others are fearful." A stop-loss forces you to be fearful right alongside everyone else, selling into a panic precisely when the best bargains might be appearing.
===== How Stop-Loss Orders Actually Work =====
If you do decide to use a stop-loss, it's crucial to understand the different types and their hidden risks.
==== The Standard Stop-Loss Order ====
This is the most common type. When the stock hits your stop price, it immediately converts into a [[market order]]. A market order tells your broker to sell at the best price currently available.
  * **The Hidden Risk: [[Slippage]]**
  In a calm market, your sell price will likely be very close to your stop price. However, in a chaotic or [[volatile market]], the price can "gap down" in an instant. Your stop price of $90 might be triggered, but the next available trade might not happen until $85. This difference between your expected price and your actual execution price is called slippage, and it can turn your planned small loss into a much larger one.
==== The Stop-Limit Order: A Bit More Control ====
To avoid slippage, you can use a stop-limit order. This is a two-part command:
  - **The Stop Price:** The price that activates the order (e.g., $90).
  - **The Limit Price:** The //lowest// price at which you are willing to sell (e.g., $89.50).
Once the stock hits the $90 stop price, it doesn't just sell at any price; it places a [[limit order]] to sell at $89.50 or better. This protects you from selling at a disastrously low price.
  * **The Hidden Risk: No Execution**
  The trade-off is that your order might not get filled at all. If the stock price plummets straight past your limit price (e.g., opens for trading at $88 after bad news), your order to sell at $89.50 or better will just sit there, unexecuted, as you watch the stock continue to fall.
==== The Trailing Stop: A Moving Target ====
A [[trailing stop-loss]] is a more dynamic version designed to protect profits. Instead of a fixed price, you set a "trailing" amount, either as a percentage (e.g., 10%) or a dollar value (e.g., $5) below the current market price.
  * **How it works:** If you buy a stock at $100 and set a 10% trailing stop, your initial stop price is $90. If the stock rises to $120, your stop price automatically adjusts upward to $108 (10% below $120), locking in some of your gains. The stop price only moves up, never down. If the stock then falls from its $120 peak, the order will trigger if it hits $108.
===== Should You Use a Stop-Loss? =====
For a dedicated value investor, the answer is generally //no//. The best defense against permanent loss is not an arbitrary price trigger but a deep understanding of the business you own and a purchase price that provides a significant [[margin of safety]]. A stop-loss can prematurely kick you out of a great long-term investment due to short-term [[market volatility]], a phenomenon known as being "whipsawed."
Your decision to sell should be a conscious one, based on one of three conditions:
  - You have found a much better investment opportunity.
  - The company's fundamentals have deteriorated, invalidating your original thesis.
  - The stock price has risen so high that its [[valuation]] is no longer rational.
While automatic stop-losses offer a tempting sense of control and discipline, true investment discipline comes from your research and temperament, not from an algorithm. The only "stop-loss" a value investor truly needs is the one in their own well-researched mind.