The stop loss is one of the basic tools of risk management for traders, as it can prevent major losses. However, one weakness of the stop loss, is that when it is triggered, it doesn't produce a sale at the stop loss price. Instead, the stop loss triggers a sale at the market price that pertains when the stop loss is triggered.
At first, these may seem to be very much the same thing. In a normal market, they generally are. Say that you have a stop loss on a stock set at GBP 4.75. The stock trades below that price during a market session, triggering the sale of your shares - probably close to GBP 4.75, minus the spread - let's say GBP 4.73.
Now let's consider a different market scenario. The London Stock Exchange closes for the day with your stock trading at GBP 4.90. Overnight, an unexpected event occurs that the market sees as very bad news. When trading opens, your stock opens at GBP 4.00, way below your stop loss. Nevertheless, your stop loss is triggered, and the sale takes place at let's say GBP 3.98 (to account for the spread).
It can be much worse if there's panic selling and a time delay in executing orders because the trade will be executed at any price. In this way, the stop loss may protect a trader in one set of market conditions but be of little use in a different context. And the triggering of stop losses may add massive momentum to a downward spike, as market orders pile up.
Don't forget that this process is exactly the same if you have shorted a stock, except that the stop loss will be above the price at which you shorted, and you will be seeking protection against unexpected rises in the market.
Sudden rises or falls are an example of the way in which a simple stop loss is just a market order, not a guarantee that can always save you from a thumping loss. When the market "gaps" like this - moves in very large, rapid steps - a stop loss is unable to perform its risk management job.
For this, you need a guarantee, that once the stop less level is triggered, your stock will be sold at the price specified. This is a "guaranteed stop" - it offers much better protection to the trader but it comes at a price.
When you are entering your trade, most online trading platforms will offer the option of a guaranteed stop and will adjust the margin requirement or deposit required, to reflect the cost of the guarantee. For example, the LCG website quotes the cost of the guaranteed stop loss wherever the guarantee is available. The premium is charged to the trader's account when the position is opened.
You can't usually use Trailing Stops< with guaranteed stops. Other restrictions are that guaranteed stops are only available in certain markets, and you can't usually put one in place if the market isn't open. Most brokers take guaranteed stop requests at their discretion, so they may decline an unusual request.
Guaranteed stops come at a price, but by limiting risk they can help a trader to survive when markets are very volatile. Next: Learn more about guaranteed stop-loss orders (a stop loss order with an extra feature).
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