A stop-loss order is designed to prevent significant losses on an investment. When you enter a stop-loss order, you choose a price at which you want to sell your investment. As soon as that price is hit, your order will execute at the next available trading price. You cannot enter a stop-loss order for most traditional mutual funds, which are known as open-end funds. You can, however, enter stop-loss orders on closed-end funds.
Open-End Funds
An open-end mutual fund is the traditional type of mutual fund that you buy directly from a mutual fund company. Most well-known mutual funds are open-end funds. You cannot enter a stop-loss order for an open-end fund because it doesn't trade on the open market and it is only priced once per day, at the close of trading. This can be a problem if the market is in free fall, because if you sell you will only get the fund price at the end of the day. You cannot sell an open-end mutual fund in the middle of the day, even if you think the market will be lower by the end of the day.
Closed-End Funds
A closed-end fund is still a mutual fund but it looks and acts very differently than an open-end fund. A closed-end fund trades on the stock market like any other stock. You may not even realize that a stock you buy and sell is actually a closed-end fund. With closed-end funds, you can enter a stop-loss order just like you would with any other stock. For example, if you enter a stop-loss at $120 per share and that fund ever trades at $120, your order will be activated and you will sell your fund at the next price at which it trades.
Volatility
Stop-losses are generally used to prevent small losses from growing to larger losses, or occasionally simply to protect profits. Stop-losses can be particularly valuable with volatile stocks, as a small loss can rapidly become a major loss. Open-end mutual funds are generally diversified investments that are not as volatile as individual stocks. As a result, being unable to enter a stop-loss order on an open-end fund is usually not a big handicap. If the market is down dramatically and you want to get out of your fund, you can enter a regular sell order and get out at the closing price for the day. With individual stocks, having a stop-loss ability can be more critical because if the stock market is down 10 percent an individual stock could quite possibly be down 20 percent, 30 percent or even more.
Stop-Loss Risks
The ability to enter a stop-loss order can be a double-edged sword. While a stop-loss can theoretically prevent a greater loss, it could actually trigger a sale at a very unfavorable price. A stop-loss order does not guarantee that you will get out of your closed-end fund at the specified price. Rather, your stop-loss order will execute at the first trade below your stop-loss price, which can be dramatically lower. For example, suppose you enter a stop-loss price of $60 on a closed-end fund trading at $65. If bad news hits the markets overnight, it's possible the fund will start the day trading at $55. Even though your stop-loss is entered at $60, your order will execute at $55. Your stop-loss cannot protect you against major market gaps downward.
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Writer Bio
After receiving a Bachelor of Arts in English from UCLA, John Csiszar earned a Certified Financial Planner designation and served 18 years as an investment adviser. Csiszar has served as a technical writer for various financial firms and has extensive experience writing for online publications.