Stopped Out: What it Means, How it Works, Example

What is Stopped Out?

Stopped out is a term used in reference to the execution of a stop-loss order. Often times, the term stopped out is used when a trade creates a loss by reaching a user-defined trigger point where a market order is executed to protect the trader's capital. This exit trade may be triggered automatically or manually. The phrase may also be used to describe what happens to a trader who sets a trailing stop loss so as to capture profits from long-running trend trades. In this case the trade may actually be profitable, but the exit keeps those profits from evaporating.

How Stopped Out Works

The phrase stopped out refers to exiting a position. Most of the time that exit will come by the use of a stop-loss order. This order is an effective tool for limiting potential losses, even if they are unexpectedly executed during times of high volatility. Often times, the term stopped out is used in a negative connotation when a trader’s position is unexpectedly sold, because it implies the trader made a loss.

Traders can be stopped-out while being either long or short in any type of security where stop-loss orders can be placed. Such orders, or their equivalent manual technique, are often used by day traders in the equity, options and index futures markets.

Traders are often stopped out when a market whipsaws, or moves sharply in one direction before returning to its original state. For example, a stock may whipsaw during an earnings announcement or other market moving event.

Special Considerations

Though earnings announcements typically happen before or after trading hours, this same scenario can play out over the course of two separate trading days. Many traders try to avoid being stopped out unnecessarily by employing one or more techniques. Traders have a couple different options to avoid getting stopped out, but none is without risk.

The first is to use a mental stop, meaning that they keep a stop-loss price in mind rather than placing an actual order. By doing so, the trader can avoid being stopped out during a whipsaw. The risk is that the whipsaw never occurs and the stock continues to move in the wrong direction. When they do finally exit the trade, the loss is worse than it might have been. In many ways, mental stops negate the entire purpose of using stop-loss points to mitigate risks since there’s no guarantee that the trader will remember or choose to actually sell shares.

Another technique is to use use options or other forms of hedging as an alternative to stop-loss orders. By using put options, for example, traders can hedge a stock position without actually selling the shares. A trader who owns 100 shares of a stock may purchase a put option on those shares with a strike price equal to the desired stop-loss point. If the stock were to whipsaw, the option trade would protect against downside without prematurely selling the shares.

Example of Stopped Out

Suppose a trader buys 100 shares of stock at $100 per share and sets a stop-loss at $98 and a take-profit order at $102 ahead of a key earnings announcement. Suppose also that the earnings announcement happened during the trading day (this is rarely done nowadays). After the earnings announcement, imagine the stock moves sharply lower to $95, and then rapidly rises in price back up to $103. Unfortunately for the trader, they would have would have been stopped out.

If the share price made an orderly drop to $95, stepping down a bit at a time along the way, the trader would have been stopped out at $98 due to the stop-loss order they had placed. However, even if the price dropped all at once directly to $95, the trader would have not only been stopped out, but would have had to take a price of $95, not $98.