When you start trading in the stock market, you will come across new and unfamiliar terms, one of which is ‘Stop-Loss’.

In the financial world, when a trade goes against you, a stop loss order is part of your exit plan.

Let’s look into it in detail.

What is Stop-Loss?

Stop loss meaning: Stop-loss, also known as ‘stop order’ or ‘stop-market order’, is a very powerful tool used by investors/traders to limit their losses.

This is an automatic order or limit that an investor places with the stockbroker by paying a certain amount of brokerage. By placing a stop-loss order, the investor instructs the broker to sell a security when it reaches the pre-determined share price limit.

For example,

Let’s say Ravi bought 100 shares in Asian Paints Ltd. at the rate of Rs. 1500 per share.

A few months later, the share price falls to Rs. 1430 per share.

Ravi wants to limit his losses; so he inputs a stop-loss order at Rs. 1380. If the share price of Asian Paints Ltd. corrects further to Rs. 1380, his stockbroker will sell the shares to prevent further losses.

On similar lines, if the share price jumps to Rs. 1800 per share, Ravi would want to hold on to his shares and not lose his advantage. So he inputs a stop-loss order to sell the shares if the price falls to Rs. 1650.

By placing the stop-loss order at this price point, Ravi protects his investments by retaining his gains and preventing potential losses.

The concept of stop-loss can be used for both short-term and long-term trading. Also, most brokers do not charge extra fees for this type of service, making it more effective for the investors.

As an intraday trader, you should always use a stop loss tool on your trades. This will let you know how much you stand to lose on a given trade.

Read more: What is intraday trading? How does it work?

Types of Stop-Loss orders

There are 2 types of stop-loss orders:

1. The Fixed Stop

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.

2. The Trailing Stop

Trailing stops are the favorite way to take profits home.

A trailing stop order works to lock certain profits while permitting the trend to create additional profits for an investor.

Trailing stops help investors by enabling them the potential to stay in a profitable position yet have the comfort of protected profits. Most investors like to convert fixed stops to trailing stops once a certain amount of profit is realized.

While most investors simply take the calculating guess when it comes to how far away to set stops both trailing and fixed. The number is often chosen based on how much-invested amount you are comfortable losing.

Advantages and disadvantages of using a stop-loss order

Advantages

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 stop loss 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 using stop 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.

How to set up a stop-loss order?

A stop-loss order is basically an automatic trade order given by an investor/trader to his or her brokerage only be executed once the price of the stock in question falls to the pre-determined stop price stated in the investor’s stop-loss order.

Setting a stop-loss limit to your trade is very easy.  When you open a deal in your trading account, you will see an option to ‘Add Stop-Loss’.

Simply choose a price point (meaning, the price up to which you are willing to lose on the specific trade), or, alternatively, set an exact rate or time-bound in which the deal will automatically close.

Read more: Who can invest in the Indian stock markets (eligibility)?

The real challenge with stop-loss is figuring out which price limit to set, but with a bit of practice, you will discover these automatic orders become extremely useful in your day to day trading in stock market.

But if you want to take a calculated risk, here are the 3 ways of deciding on stop-loss limit point in your trade.

1. As per traders’ discretion

Before taking a trade, a trader has to decide on how much risk he/she is willing to undertake in a particular trade.

It is important for a trader to evaluate one’s risk-taking appetite to effectively engages in trading activities. It is always advisable to have in place a risk calculation mechanism for each deal in the stock market.

2. Support and resistance method

Historically, it has been observed that the price of the stock starts falling and suddenly halts at particular support levels. It is always logical to set stop-loss immediately below these critical support zones to minimize your loses.

3. Moving average method  

Adding a moving average to a stock chart which is under consideration and using this as another method to identify the stop-loss point.

Generally, it is good to use a moving average which suits a particular stock. This would ensure and also avoid setting stop-loss too close to the price of the stock and getting whipped out of the trade too early.

Once the moving average is studied, all that is needed to be done is to set stop-loss immediately below the level of the moving average.

The Bottom Line

Even though there are few limitations of using stop-loss concept while trading, it is a very useful tool to limit your losses.

For most investors using a stop loss market order as their regular stop loss is highly beneficial and it assures them to get out of losing trades automatically, so they aren’t tempted to gamble and let losses mount.

If you are a new trader and not have the skill set to decide ‘quickly’ the price action of a share, then you should definitely learn the proper stop loss placement techniques.

Happy Investing!

Disclaimer: the views expressed here are of the author and do not reflect those of Groww.