Learn the stock market › Risk › Lesson 3 of 5

Does a stop loss work?

Short answerA stop loss is a decision made in advance to sell if the price falls to a set level, often placed as a stop order. It limits how badly a purchase usually goes, but it also sells often for nothing. On the 20 largest US companies, bought every month since Jan 3, 2000 and held a year, a stop 10% below the buying price sold in 49% of cases. The average for the year came to +18.9% with the stop and +29.3% without.

How a fixed stop works

You buy a stock at $200 and decide to sell if it closes at $180 or lower, 10% below the buy. The stop stays at $180 even if the price rises. It can be placed as a stop order with your broker, see the lesson on order types. A stop guarantees no price: if the stock opens far below the level, that is where it sells.

A stop against holding

Here each company is bought on the first trading day of every month since Jan 3, 2000 and held for a year, once with a fixed stop and once without. Whoever sold kept the cash for the rest of the year.

Stop	Sold	Average with the stop	Higher a year after buying
10% below	49%	+18.9%	71%
20% below	27%	+24.4%	67%
30% below	16%	+26.7%	65%

Bought on the first trading day of each month since Jan 3, 2000 and held a year, 5,307 periods in 20 companies. Sold at the first close at or below the stop, then cash without interest. The last column covers the periods that were sold.

Without a stop, the average for the year was +29.3%.

All three stops gave a lower average than holding the stock.

With a 10% stop, 49% of the purchases were sold. In 71% of those, the stock stood higher a year after buying than the price it was sold for. With a 20% stop, 27% were sold, and in 67% of them the stock stood higher a year after buying.

The stop did protect against the worst years. The worst year without a stop gave −86%, with a 10% stop −48%. It could get that bad despite the stop because the price can fall past the level in a single day. On average a 10% stop sold at −11.9%.

What the test does not show

These are the largest companies today. Those that went bankrupt or dropped out of the market are missing, and that is exactly where a stop would have helped most. So the test shows how a stop did on companies that survived. Commissions and taxes on each sale are left out, and so is buying back after a sale. The test works on closing prices; a stop that applies during the day sells more often.

How many shares a purchase can be once you have decided where to sell is worked out by the position size calculator.

Test yourself

You buy at $200 with a stop at $180. The stock closes at $190 and opens the next day at $160. What happens?