There are two main reasons why you’d place a stop-loss order
To protect your profits
Let’s say a week ago you bought 100 shares in company Y at $20 a share. Today those shares are worth $100 each. You want to keep your shares in case the price keeps rising, but you also want an insurance policy.
You know that any number of things could cause the share price to drop back down again (the wider sector is taking a hit, the company’s quarterly earnings report is due, and it’s unlikely they’ve hit their targets etc).
If you place a stop-loss order for $80 a share and the share price for Company Y falls to $80, your shares will be sold. If you hadn’t placed the stop-loss order, you risk holding onto your shares while the share price drops back to the price you paid (or below). That sweet profit you’d already mentally spent is gone, and you’re back at square one.
One of the risks you take when placing a stop-loss order is that the some markets can be relatively volatile. For example, over a typical US share market trading day, share prices can swing up or down so your stop-loss could cause you to sell your shares as the share price drops, but the price could then increase again. This means you’d have missed out on the opportunity to hold those shares and benefit from share price increases.
2. To reduce your losses
This works very much the same as protecting your profits, but in this case, your motives are a little different. Instead of trying to ensure you still make a profit by selling shares using a stop-loss order, you’re just trying to minimise the losses.
In this case, investors would place a stop-loss order if they are uncertain of the future of a company. A recent example might have been when COVID-19 started to come onto the global radar in January 2020. If an investor had just paid $100 for shares in a cruise line, they might have been concerned about the potential impacts on the industry.
They wanted to hold onto their shares in case COVID-19 was a non-event (if only!), but they placed a stop-loss order for $80, believing that a share price drop of that size would indicate massive damage to the industry. They sold their shares for less than they paid for them, but didn't risk holding onto shares that continue to decrease in value in the short term - with no guarantee of it increasing again.
Stop-loss orders and inverse ETFs
Inverse ETFs are designed to be "traded" and are speculative, so before you consider investing in them, do your research and understand the risks! Stop-loss orders can help you limit your losses when you invest in inverse ETFs.
If you make a stop-loss order, it’ll kick into action if share prices don’t drop as you expected them to, and the inverse ETF you invested starts dropping in value. You may still lose money, but not as much as you could have otherwise.
🚨 Important: You can only have one pending sell order for each share you own (i.e. if you own 1 Apple share, you can only have one pending order to sell that 1 Apple share).