What is a Stop-Loss Order?
A stop-loss order is 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.
A stop-loss order example can 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
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 trailing stop-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
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.
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.
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.
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 trading also 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.
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 market cannot 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 a stop-loss trading order to ensure losses are capped if prices move unfavourably.