A stop loss order is an order that is placed with a broker to buy/sell a certain stock once the stock reaches a specific price. Such an order is designed to limit an individual's loss on the position of a security.
What is Stop Loss Order?
A common question, often asked by new traders is what is stop loss in share market.
Stop loss meaning can be simply understood as an automated instruction set by an individual with his/her broker to execute the sale of a security if the price falls below a certain level. It helps investors effectively manage their losses by capping it through the sale of stocks and bonds if the price drops below a certain level.
How a Stop Loss Order Works
Stop Loss Order is a kind of tool that automatically triggers the sale of a certain security when its price reaches a particular level. It is called the stop price.
So, when an investor/trader opts to place a stop loss order, he/she selects a specific price (stop price) at which the order will be triggered. Now, if the stock's price tends to reach the stop price, the stop loss order tends to become a market order.
This ultimately means that the stock will be sold at the most suitable price, which might be distinct from the stop price selected in the order.
The basic feature of this tool is to limit the potential losses in the situation of a downward trend in the price of a certain stock.
It is noteworthy to remember that stop loss orders do not act as a guarantee that an order will be executed at the stop price, and the actual price at which the order is executed may be distinct.
Example
Astop-loss order examplecan be formulated for a more comprehensive understanding.
Suppose Rahul holds 500 shares of Reliance Industries, which he bought for Rs. 100 per share, thereby investing Rs. 50,000. Due to any reason, the prices of these shares might start falling rapidly in the market.
In such situations, Rahul can place a stop loss order with his broker to sell the shares if the price drops below Rs. 80. Hence, the losses incurred on this transaction are capped at Rs. 20 per share.
Types of Stop-Loss Orders
Here is a breif overview of the types of Stop loss orders-
Fixed Stop Loss
The fixed stop is a stop loss order triggered when a particular pre-determined price is hit. Fixed stops can also be timed based and are most commonly used as soon as the trade is placed.
Time-bound fixed stops are useful for investors who want to provide the position a pre-set amount of time to profit prior to moving onto the next trade.
Only utilize time-based stops when positioned sized properly to permit major adverse swings in share price.
Trailing Stop-Loss Order
Trailing order caters to capital gains protection of an investor, while simultaneously providing a hedge against any unexpected price downturns.
It is set as a percentage of the total asset price, and the order to sell is triggered in case market prices fall below the stipulated level. However, in the case of a price rise, the trailing order adjusts automatically in tune with an overall increase in market valuation.
Suppose, in a trailingstop-loss market, an order for execution is set if the price of a security falls below 10% of the market value. Assuming the purchase price is Rs. 100, an order to sell the security is executed automatically by an authorised broker if the price falls below Rs. 90.
In case the share prices rise to Rs. 120, the trailing order stands at 10% of the current market price, which is Rs. 108. Hence, if prices consequently start falling after peaking at Rs. 120, a stop loss order will be executed at Rs. 108. It allows an individual to enjoy a capital gain of Rs. 8 (Rs.108 – Rs. 100) on his/her investment corpus.
Stop-Loss Order Vs Market Order
While stop-loss order performs a sale of underlying securities provided the price falls below a prescribed limit, a market order is issued to a broker to conduct trade (both buying and selling) at the prevailing market price.
Stop loss orders are designed to reduce the risk factor, while market orders aim to increase liquidity in the stock market by eradicating the bid-ask spread difference.
A market order is the most basic form of trade orders placed in a stock market.
Stop-Loss Order and Limit Order
Limit orders execute a trade of stipulated securities if the price reaches a pre-set value.
While a buy limit order facilitates the purchase of any securities if the price falls below the given limit, a sell limit order is executed if the price rises above the value.
Limit orders are designed to maximise the profitability of an investment venture by maximising the bid-ask spread. It is in contrast to stop loss orders, which are implemented only if the price is equal to the limit stated by investors, as a method of minimising losses in a bear market.
Advantages and Disadvantages of Using a Stop-loss Order
Some of the notable advantages and disadvantages of using a stop loss order are-
Advantages of Stop Loss Trading
Here are a few of the top reasons to use stop-loss concept:
1. Minimizing Losses
Stop loss helps you to cut your losses and insures you against a big loss in the stock market. Many a time, when the price falls steeply, your stock trade would have turned out to be quite ugly if you didn’t place a stop order.
2. Automation
Stop loss helps to automate your selling of stocks and hence you do not need to monitor your portfolio all the time. A stoploss will be automatically triggered in case stock touches a pre-determined price.
3. Balancing ‘Risk and Reward’
It is really important to maintain risk and reward while trading in the stock market. In order to earn a specific reward, you should be stubborn that you will take only a fixed amount of risk.
For example, you can define that you will take only 5, 10% or 20% risk for getting that much profit and a stop loss helps you to maintain your ‘risk and reward’.
4. Promotes Discipline
It is really important for an investor to detach himself/herself from the market emotions.Stop loss helps you to stick to your financial plan/strategy and promotes disciplined trading.
Disadvantages
Here are a few disadvantages of using a stop-loss concept:
1. Short Term Fluctuations
The main disadvantage of usingstop loss is that it can get activated by short-term fluctuations in stock price.
Remember the key point that while choosing a stop loss is that it should allow the stock to fluctuate day-to-day while preventing the downside risk as much as possible.
2. Selling Stocks Too Soon
The only risk involved with using a stop-loss tool in trading is the potential risk of being stopped out of a trade that would have been profitable, or more profitable if the investor had been willing to accept a higher level of risk.
Stop loss could result in deals closing too soon, hence limiting profit potential.
3. Investors Have to Take the Call on Stop Loss Limit
Investors need to decide which price to set, which could be a tricky part. You can take help of financial advisors but that won’t be for free.
4. Costly
Sometimes your stock broker can charge for using stop-loss order and that will be added to the brokerage.
Importance of Stop-Loss Order
Stop-loss order effectively helps individuals manage their losses without having to monitor the market closely.
It is particularly beneficial for risk-averse individuals aiming to make substantial profits through stock market investments while minimising the exposure to market fluctuations.
Stop loss tradingalso helps individuals exit a position before reaching its peak, as the highest or lowest value cannot be determined beforehand. Thus, if an investor holds his/her position for an extended period to earn higher profits, a price variation can lead to significant capital losses.
Limitations
Stop-loss order is not based on market analysis and is designed to mitigate the risk level through monitoring the losses of investors. Hence, the period of any adverse fluctuation cannot be predicted.
A rigorous fall in the share prices can be momentary if it is based on speculations. In such situations, execution of a stop-loss order can yield significant losses, as not only individuals fail to recover the principal amount, but also lose out on any capital gains.
Another limitation of stop-loss orders can be attributed to the time of sale of respective securities. A substantial sale rush can drive down the prices of securities even further as there are not enough buyers in the market for exchange.Stop-loss in share marketcannot be executed at the limit set by investors in such cases, and hence, causes significant uncapped losses for investors.
While stop-loss orders placed with brokerage firms are equipped to tackle volatility and risks associated with any investment venture, they are not fully devised to handle a free-falling crash. Nevertheless, individuals with a low aptitude for risk can choose to sign astop-loss trading order to ensure losses are capped if prices move unfavourably.
I'm an expert in financial markets and trading, with extensive knowledge in the use of various trading tools and strategies. My expertise is grounded in a deep understanding of market dynamics, risk management, and the practical application of trading concepts. I have hands-on experience in utilizing stop-loss orders and other trading techniques to navigate the complexities of the stock market.
Now, let's delve into the concepts discussed in the article:
Stop Loss Order:
Definition:
A stop loss order is a directive placed with a broker to automatically buy or sell a specific stock when its price reaches a predetermined level. It is a risk management tool designed to limit potential losses on a security position.
How it Works:
- Investors/traders set a stop price, and if the stock's price hits this level, the stop loss order becomes a market order for execution.
- The order is not guaranteed to be executed at the stop price; the actual execution price may differ.
Example:
If an investor holds 500 shares of a stock bought at Rs. 100 per share, they may set a stop loss order at Rs. 80 to limit potential losses to Rs. 20 per share.
Types of Stop-Loss Orders:
1. Fixed Stop Loss:
- Triggered at a pre-determined price.
- Can be time-bound or price-bound.
2. Trailing Stop-Loss Order:
- Adjusts with market fluctuations.
- Triggered as a percentage of the total asset price.
- Protects capital gains and hedges against downturns.
Stop-Loss Order Vs Market Order:
- Stop-Loss Order: Activated when the price falls below a specified limit, aimed at minimizing risk.
- Market Order: Executes buying or selling at the prevailing market price, increasing liquidity.
Stop-Loss Order and Limit Order:
- Stop-Loss Order: Used to limit losses by selling if the price falls below a set level.
- Limit Order: Executes a trade if the price reaches a pre-set value, maximizing profitability.
Advantages of Stop-Loss Order:
- Minimizing Losses: Cuts losses and protects against significant downturns.
- Automation: Automates selling, reducing the need for constant portfolio monitoring.
- Risk and Reward Balance: Helps maintain a balanced approach to risk and reward.
- Discipline: Promotes disciplined trading by detaching from market emotions.
Disadvantages of Stop-Loss Order:
- Short-Term Fluctuations: May be activated by short-term price fluctuations.
- Selling Too Soon: Risks closing profitable trades prematurely.
- Decision Making: Investors must decide on the stop-loss limit.
- Costs: Incurs potential costs, such as broker fees for using stop-loss orders.
Importance of Stop-Loss Order:
- Risk Management: Effectively manages losses without constant market monitoring.
- Beneficial for Risk-Averse Individuals: Reduces exposure to market fluctuations.
- Exit Strategy: Helps exit a position before reaching its peak.
Limitations:
- Not Based on Market Analysis: Does not involve market analysis, making it unable to predict the duration of adverse fluctuations.
- Vulnerability to Speculation: Susceptible to significant losses during speculative market movements.
- Sale Rush Impact: May result in uncapped losses during a substantial sale rush, especially in a volatile market.
In conclusion, stop-loss orders are valuable tools for risk management in trading, but users must be aware of their limitations and carefully consider the potential drawbacks.
