What is Stop Loss in Share Market?
Stop-loss Order Meaning: A stop-loss order is a buy or sell order placed with a stockbroker, executed after a specific price point. They are protective measures used against price drops. A stop-loss order ensures minimal losses. A stop-loss order means that it will stop a loss from happening. The way it works is that you set a trigger price.
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Stop-Loss Order: Example
Say, as an example, you buy a share for 120 rupees. With the help of your research, you believe that it will give you 100% returns. You would like to stay locked in as long as you can. The only downside is that if the stock falls by 25%, it will never recover.
So you would like to ensure that you don’t incur huge losses if the price drops below 25% of the current market price. You can set up a stop-loss order as a precaution. You have a trigger price that you set. You can set it at about 100 or maybe 95 if you want closer to the 25% loss amount.
So what would happen is if the stock price does manage to fall to 95 and below, your shares will be sold at 95, ensuring you face no further losses. In another scenario, if you bought a share at 100 and it has soared to 145, and you feel it might drop, you can set the stop loss to 120 or higher to ensure you book a profit in case the price will drop lower.
So in case the share drops below 120, you still keep the profit of 20. For such a situation, let’s say the stock’s share price has declined for a while now. But you can see a reversal happen. If you’re unsure, you can place a buy stop-loss order just above the break-out price, ensuring that you will also buy into the bullish trend when the price crosses the point.
What is the Importance of Stop-Loss Orders:
Risk Management: Stop-loss orders help manage risk by limiting potential losses. By setting a predefined exit point, investors can protect themselves from significant downturns in the market.
Emotional Control: Stop-loss orders help remove emotional decision-making from trading. By automating the exit process, investors can avoid making impulsive or fear-driven decisions during volatile market conditions.
Capital Preservation: Stop-loss orders are essential for preserving capital. By cutting losses at a predetermined level, investors can avoid large drawdowns and maintain a healthy portfolio balance.
Advantages of the Stop-Loss Order
Protection Against Downside Risk: Stop-loss orders protect market downturns by ensuring that positions are automatically exited if the price falls below a specified threshold.
Automation: Stop-loss orders can be set in advance, allowing for automation and reducing the need for constant market monitoring. This frees up time for investors to focus on other aspects of their trading strategy.
Peace of Mind: Knowing that a stop-loss order is in place can provide peace of mind to investors, as they have a predetermined plan for managing potential losses.
Disadvantages of Stop-Loss Orders
The use of stop-loss orders has some drawbacks. For starters, putting up a stop-loss order does not restrict an investor’s damage to the difference between the buy price and the fixed sale price. If a firm releases poor earnings after the market closes, for example, its share price may be significantly below an investor’s stop-loss price by the start of the next trading day.
Another possible disadvantage of stop-loss orders is that they can cause a stock sell even if the stock price merely falls marginally below the trigger price before swiftly rebounding. If a stock’s price is fluctuating, or if another event occurs that prompts a quick sell-off by other investors, an investor’s stop-loss order may be triggered.
Finally, amid substantial market drops, experienced investors such as hedge fund operators may attempt to exploit the availability of stop-loss orders. Known as “stop hunting,” investors short stocks that are already dropping in order to drive prices lower in order to trigger a deluge of stop-loss orders. Following that, these investors begin purchasing those identical companies in order to profit from a predicted comeback.
Types of Stop-Loss Orders:
Market Stop-Loss Order: This type of stop-loss order is triggered when the price of an asset reaches or falls below a specific level. Once triggered, the order is executed at the next available market price.
Limit Stop-Loss Order: With a limit stop-loss order, you can specify a specific price for triggering your stop-loss order. Once the price reaches or falls below your specified level, the order becomes a limit order and is executed at the specified price or better.
Trailing Stop-Loss Order: A trailing stop-loss order is designed to protect profits by adjusting the stop-loss level as the price of the asset moves in a favorable direction. Since the order was placed, the stop-loss level is set as a percentage or fixed amount below the asset’s highest price.
Limitations of Stop-Loss Orders:
- Stop-Loss Triggers: During periods of high volatility or rapid market movements, stop-loss orders may be triggered at prices significantly different from the expected exit point. This is known as slippage and can result in higher losses than anticipated.
- Whipsawing: In volatile or choppy markets, prices can quickly reverse after triggering a stop-loss order. This can result in premature exits and missed opportunities if the price rebounds.
Conclusion
A stop-loss order is an order made with a broker to purchase or sell a particular stock at a predetermined price. A stop-loss order is intended to restrict an investor’s losses on a security holding. Setting a stop-loss order 10% below the price at which you purchased the stock, for example, will restrict your loss to 10%. Assume you recently acquired Microsoft (MSFT) at a price of $20 per share. You place a stop-loss order for $18 immediately after purchasing the stock. If the price of the stock goes below $18, your shares will be sold at the current market price.