What is a Hard Stop?
A hard stop is an instruction from a client to their broker which informs them to sell units of a security when the market price declines to a specific level. Hard stops are used to minimize risk and reduce potential losses in the financial market when price fluctuations and unexpected events occur.
A hard stop can also lead to missed gains if the security experiences a price recovery or rebound after the hard stop is executed.
A hard stop will continue until the order is filled or cancellation occurs. It is also referred to as a “stop-loss order” or a “stop order.”
Hard Stop vs. Soft Stop
When a client is trying to reduce the potential risk associated with investing in securities, they may ask their broker for a hard stop. This allows the broker to automatically sell the client’s securities when they reach a minimum price.
Also referred to as a “mental stop,” a soft stop is an unofficial price at which financial traders believe it is time to exit a losing position. In this case, the trader can have a numeric exit value in mind without setting up a hard stop.
Avoiding the biggest downfall of a hard stop, a soft stop allows the trader to evaluate the financial market and decide if the share will recover after a price level stop (rather than the share being automatically sold when the stock reaches the specific hard stop price level).
Advantages of Implementing a Hard Stop
When purchasing a stock, it is beneficial to evaluate some of the other important considerations and factors that play into how it is treated. Listed below are the advantages of implementing a hard stop for your security.
- A hard stop reduces an investor’s loss on a security position.
- It reduces the time spent monitoring the holdings.
- No costs are associated with its implementation.
- It decreases emotional stock connection by automatically selling the stock once it reaches a value below the limit.
- Hard stops can be canceled at any time.
Disadvantages of Implementing a Hard Stop
Apart from the advantages, it is also extremely crucial to evaluate some of the disadvantages to ensure that the most educated trading strategy is made. Listed below are the disadvantages of implementing a hard stop for a security.
- Potential future gains are lost if the price level recovers after a hard stop sale.
- Short-term volatility could activate the hard stop price quickly.
- Once the hard stop price is met, it is sold as a market order, potentially resulting in a sales price lower than the original hard stop price.
- Certain securities, such as penny stocks, restrict the use of a hard stop.
In order to illustrate the process of a hard stop, we will be looking to deal with a broker, a client, and a number of price levels.
For example, in January, assume that a client purchased 500 shares of stock in XYZ Company for $20/share.
Since the client would like to minimize potential losses, he decides to ask his broker to put a hard stop if the shares reach any value below the purchase price.
As seen in the graph, the share price of XYZ Company began to reach a level below $20 between September and October. Once the price level reaches any value below the hard stop line, the shares are automatically sold at the best price available.
Setting a financial hard stop for securities can be beneficial because it can potentially reduce the client’s financial loss. But in this case, it is seen that the hard stop prevented future gains when the stock price shot back up to $25 in December.
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