A stop loss also called stop-loss order or stop market order, is an order whereby an investor instructs the broker to automatically sell his/her stocks if the price of the security drops to a certain level.
In other words, stop loss can be defined as an advance order to sell an asset when it reaches a pre-set price point.
The method of stop loss is used to limit the gain and loss while executing a trade.
In this article
- How Does it Work?
- Is There any Rule for Placing a Stop Loss?
- Advantages of the Stop-Loss Order
- Disadvantages of Stop loss
- Things to Keep in Mind
How Does it Work?
A stop loss, by design, limits an investor’s loss on security. For example, let’s assume you own 10,000 shares of a company ABC. You have paid Rs.15 for each share, and you expect the scrip to generate around 20% returns in a few months.
On the flip side, you have macro headwind over the economy. Moreover, you are well versed with the fact that you can’t predict market movement accurately and thus you would want to constrain your losses if the stock moves against your expectation.
You don’t wish to lose more than Rs. 25000 which is Rs 2.5 per share. Thus, you put a stop loss of Rs.14 in your order.
By doing this, you aim to constrain your losses, and if your stock sees any downward movement, it will be automatically sold if the price falls to Rs. 12.5 from Rs.15 of your invested price.
By putting stop loss in your order, you direct your broker to sell the shares if the value comes down to Rs.12.5. In case the price moves up; your broker does nothing.
Is There any Rule for Placing a Stop Loss?
There is no rule regarding the level at which stop loss should be placed. Stop loss entirely depends on the individual’s investing style, and risk appetite. While a short-term trader may use a 5% stop loss level, a long-term investor may choose 20%.
Advantages of the Stop-Loss Order
1. No Cost of Implementation
One of the most important benefits is that it costs nothing for implementation. You don’t pay any additional commission to exercise the facility.
An investor/trader pays a regular commission (read brokerage) as prescribed by the broker in the term sheet when the stock reaches the stop-loss price, and the stock is automatically executed for selling.
2. Emotional Free Investments
Secondly, stop loss allows decision making to be free from any emotional influence.
Investors, in India particularly, tend to fall in love with their scrip which doesn’t really allow them to sell the stock, even after steep correction. Applying stop loss helps to avoid any such situation.
3. Investment Strategy Remains on Track
Stop-loss keeps the investment strategy on track without clouding your judgment with emotion. Every investor, be it value investor or growth investor, knows why he/she is investing in a particular stock and thus, he/she would be able to see the exit strategy as well.
4. No Monitoring Required
As an investor or trader, you are not required to monitor the performance of the stock daily if you have put the stop loss. The method provides convenience and is most useful when you are on vacation or do not have access to the trading terminal.
Disadvantages of Stop loss
1. Price Fluctuation Can Result in Activating Stop Loss thus Leading to Losses
Stop loss offers a disciplined way of trading to investors. But at the same time, it could increase the risk of exiting a stock too early, particularly in the case of volatile stocks.
For example, in our case, assume the stock is volatile due to varied reasons and moves from Rs.15 to Rs.13 to Rs.10 to Rs 17 in 1 month.
It has nearly reached your target of Rs.18, but did you make money?
The answer would be no, because your stop loss got activated when the stock corrected to Rs.13. Thus, you miss out on the appreciation that you anticipated.
2. Long-Term Investors Miss on Buying Opportunity
Long-term investors tend to lock in losses using a stop loss. Using it, they don’t get a chance to evaluate if the price decline in stock has created a further buying opportunity.
Things to Keep in Mind
One thing to keep in mind while opting for stop loss is that when the stock reaches the stop-loss price, the order becomes a market order and execution price could be different from the stop price.
A stop-loss is a simple tool yet traders and investors fail to use it often.
Be it to prevent excessive losses, or lock in profit, all investing styles can see benefit from the stop-loss technique. One can say that stop-loss is an insurance policy without premium – you hope not to use it but you remain comfortable knowing that you are protecting.
Disclaimer: The views expressed in this post are that of the author and not those of Groww