What Is a Stop-Loss Order?
A stop-loss order is a type of order used by traders to limit their loss or lock in a profit on an existing position. Traders can control their exposure to risk by placing a stop-loss order.
Stop-loss orders are orders with instructions to close out a position by buying or selling a security at the market when it reaches a certain price known as the stop price.
They are different from stop-limit orders, which are orders to buy or sell at a specific price once the security’s price reaches a certain stop price. Stop-limit orders may not get executed whereas a stop-loss order will always be executed (assuming there are buyers and sellers for the security).
For example, a trader may buy a stock and place a stop-loss order with a stop 10% below the stock’s purchase price. Should the stock price drop to that 10% level, the stop-loss order is triggered and the stock would be sold at the best available price.
Although most investors associate a stop-loss order with a long position, it can also protect a short position. In such a case, the position gets closed out through an offsetting purchase if the security trades at or above a specific price.
KEY TAKEAWAYS
- A stop-loss orders instruct that a stock be bought or sold when it reaches a specified price known as the stop price.
- Once the stop price is met, the stop order becomes a market order and is executed at the next available opportunity.
- Stop-loss orders are used to limit loss or lock in profit on existing positions.
- They can protect investors with either long or short positions.
- Stop-loss orders are different from a stop-limit order, the latter of which must execute at a specific price rather than at the market.
Table of Contents
Stop Loss Meaning
A stop loss is a type of order that investors or traders use to limit their potential losses in the stock market. It works by automatically selling a security when its price reaches a certain level, known as the stop price. This helps traders avoid larger losses if the price of the security continues to drop.
Stop loss orders play a crucial role in risk management in the stock market. Using a stop loss strategy, investors and traders can limit their potential losses which reduces the risk of holding a losing position. This helps in maintaining discipline and sticking to investment goals and strategies even in a volatile market condition.
Most of our decisions are based on our emotions but in the stock market, these emotions can mean financial ruin. Stop loss orders can help investors manage these emotions and avoid making impulsive decisions based on fear or greed. By setting a predetermined exit point, they can reduce the emotional stress of monitoring their investments and make rational decisions based on their investment plan.
An investor researches and sets a limit as per the previous market performance of the share typically below the current market price for a long position or above the current market price for a short position.
In simple terms, you purchased shares of X company at INR 10 per share and entered a stop loss of INR 8 right after buying these shares. Now, if the stocks fall below INR 8, your purchased shares will be sold at the prevailing market price saving you from further losses.
How Stop-Loss Orders Work
We all have seen the floating ball valve used in water tanks which automatically stops the water flow in the tanks when it reaches a certain level to stop overfilling or spillage. The very same way a stop loss order is a tool that automatically triggers the sale of a security when its price reaches a certain level, known as the stop price.
When an investor places a stop loss order, they specify a certain price, called the stop price at which the order will be triggered. If the price of the stock reaches the stop price, the stop-loss orders becomes a market order, which means that the stock will be sold at the best available price, which may be different from the stop price specified in the order.
This helps to limit potential losses in the event of a downward trend in the stock’s price. However, stop-loss orders do not guarantee that an order will be executed at the stop price and the actual price at which the order is executed may be different, especially during high market volatility.
Advantage Over a Stop-Limit Order
A stop-loss orders become a market order to be executed at the best available price if the price of a security reaches the stop price. A stop-limit order also triggers at the stop price. However, the limit order might not be executed because it is an order to execute at a specific (limit) price. Thus, the stop-loss order removes the risk that a position won’t be closed out as the stock price continues to fall.
Potential Disadvantages
One disadvantage of the stop-loss orders concern price gaps. If a stock price suddenly gaps below (or above) the stop price, the order would trigger. The stock would be sold (or bought) at the next available price even if the stock is trading sharply away from your stop loss level.
Another disadvantage concerns getting stopped out in a choppy market that quickly reverses itself and resumes in the direction that was beneficial to your position.
Investors can create a more flexible stop-loss order by combining it with a trailing stop. A trailing stop is an order whose stop price, rather than being a fixed price, is instead set at a certain percentage or dollar amount below (or above) the current market price. So, for instance, as the price of a security that you own moves up, the stop price moves up with it, allowing you to lock in some profit as you continue to be protected from downside risk.
Some traders and investors may also use option contracts in place of stop orders to allow them to control their exit price points better.
Benefits of Stop-Loss Orders
- Stop-loss orders are a smart and easy way to manage the risk of loss on a trade.
- They can help traders lock in profit.
- Every investor can make them a part of their investment strategy.
- They add discipline to an investor’s short-term trading efforts.
- They take emotions out of trading.
- They eliminate the need to monitor investments on a daily (or hourly) basis.
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Examples of Stop-Loss Orders
A trader buys 100 shares of XYZ Company for $100 and sets a stop-loss order at $90. The stock declines over the next few weeks and falls below $90. The trader’s stop-loss order gets triggered and the position is sold at $89.95 for a minor loss. The market continues trending downward.
A trader buys 500 shares of ABC Corporation for $100 and sets a stop-loss order for $90. After the market closes, the business reports unfavorable earnings results. When the market opens the next day, ABC’s stock price gaps down. The trader’s stop-loss orders are triggered. The order gets executed at a price of $70.00 for a substantial loss. However, the market continues dropping and closes at 49.50. While the stop-loss orders couldn’t protect the trader as originally intended, it still limited the loss to much less than it could have been.
What’s a Stop-Loss Order?
It’s an order placed once you’ve taken a position in a security (on the buy side or sell side) with instructions to close out your position by selling (or buying) the security at the market if the price of the security reaches a specific level.
How Does a Stop-Loss Order Limit Loss?
A stop-loss orders limit your exposure to less of a loss than you might otherwise experience by automatically closing out your position if your stock trades to an unfavorable market price level that you designate. If you use a trailing stop with your stop-loss order, that protection can move with your position even as it increases in value. So, a loss could translate to less profit rather than a complete loss.
Do Long-Term Investors Need Stop-Loss Orders?
Probably not. Long-term investors shouldn’t be overly concerned with market fluctuations because they’re in the market for the long haul and can wait for it to recover from downturns. However, they can and should evaluate market drops to determine if some action is called for. For example, a downturn could provide the opportunity to add to their positions, rather than to exit them.
Types of Stop Loss Orders
We have learned what a stop-loss order is and how it is important for an investor, now we will see the different types of stop loss orders. In general, there are two types of stop loss order:
Fixed Stop Loss Order
As the name suggests, a fixed stop-loss order is a type of stop-loss order where the stop price is set at a fixed level, typically a percentage below the market price. It allows investors to automatically trigger a sell order when the stock price reaches the predetermined stop price and limit the potential loss.
One advantage of fixed stop-loss order is we can set and remain at a constant level irrespective of the market volatility. Investors use this type of order to protect their investment and who prefer to set a constant stop-loss level.
Trailing Stop-Loss Orders
This one is a little different from the previous one. Trailing stop loss orders allow investors to set up a stop-loss level that adjusts to the price of the stock as it changes.
In simple words, a percentage is fixed which allows you to trail the growth of your share and set up a stop loss accordingly. If the price moves in a favourable direction, the stop-loss level also moves in that direction. This order helps to lock in profits while limiting potential losses in a declining market.
How to Set Stop Loss Levels
Factors to consider when setting stop loss levels
Volatility
The stop-loss should be set as per the volatility of a security. The more volatile a security is, the more important it is to have a stop loss in place
Liquidity of the stock
Some stocks trade on very thin volumes which means even if there is a stop loss in place, you may not be able to exit because there is no buyer on the other side. Therefore, buying illiquid stocks has its own set of risks, and using a stop-loss strategy becomes essential.
Position size
If you have a large position in a stock, executing it may be difficult for illiquid security. Therefore, only take positions that you feel comfortable with when you look at the size of that position vis a vis your net worth.
Determining the right stop loss level
Setting up a stop loss level is a subjective process that varies from individual to individual. A person with higher risk tolerance will set up the level a little low while on the other hand, an individual with low-risk tolerance will definitely set the stop loss level high.
One of the most popular methods of determining stop-loss levels is the percentage method. The method is very simple and effective, before setting up the stop-loss level the investor needs to determine the percentage of the stock price they are willing to give up before exiting their trade.
For example, an investor purchased a share for INR 100 and decided to set 10% of the loss to bear while exiting. So, he will set the stop loss limit from 90-100, which will limit his potential loss to 10% of the price.
Advantages of using Stop-Loss Orders
Traders consider a lot of factors while investing in the stock market. Stop loss is an effective tool that helps to reduce losses and make this decision-making process easier in the following ways:
Minimising Losses
Using stop loss orders, traders can protect their capital and ensure that they don’t experience large, irreversible losses that could put their trading account in jeopardy.
Improving Risk Management
Your portfolio will look good if you have more capital gain, by managing risk effectively and limiting losses, stop-loss orders can help traders improve their overall trading performance and achieve their investment goals.
Emotional Control
Being emotionally biassed is one of the major reasons for a bad decision-making process. Stop-loss orders take the emotion out of the decision-making process by automatically closing a trade when a predetermined level is reached. This helps traders avoid making impulsive or emotional decisions that could negatively impact their trading results.
Disadvantages of Using Stop-Loss Orders
Like every existing thing in the universe, stop loss has its negative side which one should be aware of. While stop-loss orders can be a valuable tool for managing risk, there are also some disadvantages to consider:
Slippage
The stock market is a very volatile space changing every second, the price of a security can gap past the stop loss level, leading to slippage. This means that the trade may be executed at a price that is significantly different from the stop loss level, resulting in larger losses than expected.
Guaranteed execution
The main objective of a stop loss is to limit losses but they do not guarantee whether a trade will be executed at the desired price. In volatile market conditions, the stop-loss order is executed at a much worse price which results in a higher loss.
Market gaps
There are certain gaps in the market that lead to failure of stop-loss in certain situations. For example, in markets with low liquidity, it can be difficult to execute a stop-loss order at the desired price again resulting in a loss.
Why use stop loss orders?
Stop loss orders are a way to manage risk. The truth is that you can’t eliminate all risk from trading. The financial markets are unpredictable. That means you can make a profit or lose money on a trade. However, experienced traders know that you can manage risk by controlling certain variables.
For example, you can carry out technical analysis before you take a position. You can read company reports and assess insights from experts before buying/selling stocks. You can only execute trades with money you can afford to lose. That doesn’t mean you will lose money or that you want to lose it. However, the money you use for trading should be expendable so that, if the worst happens, it won’t significantly affect your life.
These things give you more control over your trades and help to manage risk. Stop loss orders are another way of controlling the way you trade. These orders don’t stop you from losing money. What they will do, however, is limit your losses. You won’t lose more than expected because, as we’ve said, an order gets closed once the specified limit is met/exceeded.
Stop loss orders aren’t always appropriate
If you’re going to trade online and stop loss orders are available, you should almost always use them. But keep in mind that, sometimes, stop loss orders can be problematic. For example, in highly volatile markets, stop loss orders aren’t always advisable. This is because prices can rise and fall dramatically in a short time.
Let’s say you’ve set a stop loss of 10% and you’re buying securities in a volatile market such as forex. The price of a security could drop 10% and, a minute later, increase in value by 15%. These swings can happen and they’re something people who trade in volatile markets accept. Using a stop loss order in these conditions will protect you from the dramatic downswings, but they’ll also prevent you from riding the upswings.
This doesn’t mean using stop loss orders in volatile markets is a bad idea. You shouldn’t implement this risk management tool without considering the bigger picture. It might be suitable for the current conditions, but it might not be.
Only you can make that decision. As long as you understand the fundamentals of stop loss orders, what they offer, why they’re used and the market conditions, you’ll be better prepared to make the best decisions for your investing goals.
Bottom Line
While stop loss orders have some loopholes to consider, it is the most valuable tool for managing risk and limiting losses. When you make decisions more rationally the market becomes an avenue for wealth creation and not gambling.
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