How Does a Stop Loss Work?

Managing risk is a core principle in trading. One of the most widely used tools for this purpose is the stop loss. While commonly seen on trading platforms, its function is sometimes misunderstood, especially by those new to market mechanics. 

This article provides a clear, fact-based explanation of how a stop loss works, what triggers it, and how it fits into trade management.

Rather than using the traditional format of definitions followed by examples, this article explains the concept through a series of practical questions and answers to offer an alternative, structured learning approach.

What Is a Stop Loss?

A stop loss is an instruction to automatically close a trade when the price of the asset reaches a specific level. It is designed to limit how much loss can occur on a given position.

The stop loss price is set by the trader in advance. If the market price moves to or beyond that level, the platform will execute a market order to close the trade.

Is a Stop Loss a Guarantee?

No, a stop loss is not a guarantee of a specific exit price. It is a trigger. Once the set price is reached, the order is submitted to the market. The actual price at which the trade is closed may differ from the stop price, especially in volatile or fast-moving markets.

This is important when trading instruments that are exposed to price gaps or low liquidity. The difference between the stop price and the executed price is known as slippage.

How Is a Stop Loss Placed?

Stop losses are typically set at the time a trade is opened but can also be added to or adjusted afterward. The trader selects a price level below the current market price (for a buy position) or above it (for a sell position).

• In a buy (long) trade, the stop loss is placed below the entry price.
  
• In a sell (short) trade, the stop loss is placed above the entry price.

Most platforms allow the stop loss to be entered in terms of:

• Price level
• Distance in points/pips
• Amount of capital or percentage of the position

What Triggers a Stop Loss?

A stop loss is triggered when the market price reaches or crosses the stop level. Depending on the platform, this may be based on:

• Last traded price
• Bid price
• Ask price

The platform uses this price to determine when the stop condition has been met. Once triggered, the position is closed using a market order.

Does the Stop Loss Move?

By default, a stop loss is a fixed instruction. However, some platforms allow for a trailing stop, which adjusts automatically as the price moves in the trader’s favor.

Fixed Stop Loss

• Remains at the same level until manually changed.
• Only activates if the price reaches the specified level.

Trailing Stop Loss

• Moves in the direction of a favorable market movement.
• Locks in gains by following the price, but does not move backward.

Trailing stops are used to manage risk while allowing a position to remain open as long as the market trend continues.

Can a Stop Loss Be Seen by the Market?

On most retail platforms, stop loss orders are stored and managed on the server of the trading platform and are only visible to the user. In these cases, they are triggered by price feeds rather than being submitted to a central exchange. This applies particularly to over-the-counter (OTC) markets, such as forex.

How a Stop Loss Functions Works

Let’s break down the role of a stop loss into practical components:

Function	Description
Purpose	To automatically close a position at a predefined price to limit loss
Trigger	Activated when the asset’s price hits or crosses the specified level
Execution Type	Market order at the time of activation
Location (Buy/Sell)	Below entry for buy positions, above entry for sell positions
Slippage Risk	Final execution price may differ from the stop price due to market conditions

Conclusion

The stop loss is a tool used to manage outcomes when the market moves against a position. It functions by acting as a preset instruction to exit a trade under specific conditions. While it is not a guarantee of exact pricing, it provides a structured method of limiting exposure to unfavorable price movements.

Understanding exactly how stop loss orders are triggered and executed helps traders set realistic expectations when placing them in live market conditions.

<p>The post How Does a Stop Loss Work? first appeared on TradeFT.</p>

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