When an investor buys a stock, he/she expects its price to rise to a certain level. However, short-term market fluctuations may arise and result in different price levels than expected. A Stop Loss protects an investor against drastic fluctuations as he/she can give instructions to the broker to automatically sell the stock at a particular price. This price is generally set at lower levels than the price at which the stock is bought.
What is the definition of stop loss?
Stop-loss is also called ‘stop order’ or ‘stop-market order’. It can be defined as a sell order placed in advance for an asset to be sold when it reaches a certain price point. It is mainly used to minimise or limit the loss in a trade. The concept is often used for short-term trading. In this automated order, an investor reaches out to the broker/agent and pays a certain amount of brokerage to place the order.
Stop loss helps to reduce losses during share trading. There are many different types of stop-loss orders, each with a distinct objective:
- Sell stop order: This is used to restrict losses or protect profits in case a stock’s price decreases. It uses a stop price below the current market price.
- Buy stop order: This is used for purchasing stocks as insurance against any losses and protecting gains from a short sell transaction. Here, the stop price is above the current market price.
- Trailing sell stop order: The stop parameter here is based on a trailing change that is part of the actual reduction in the stock’s price. Used for maximizing profits in case a stock’s price rises or minimizing losses in case stock prices fall.
- Trailing buy stop order: Here, the stop parameter is based on a trailing change in the stock’s actual price rise. It helps to maximize profits in case a stock’s price falls or minimizing losses when stock prices rise.
- Stop-Limit order: This is an order combination of a limit order and a stop order. When the stop price is reached, the stop-limit order instructs to limit order of buying or selling securities at the specified price.
How to use stop loss?
The stop loss can be used in different ways. The most common method is to set a price. Once the stock reaches this price, an order is automatically placed to sell the stock. The broker sells the stock at the prevailing market price as per this instruction. It can also be used for short-selling, in which case, the Stop Loss price triggers a buy order. For instance, if you expect a stock priced at Rs. 100 to fall, you can set a Stop Loss at Rs. 80. Thus, if the price falls, you can still limit your loss to Rs. 20.
Fixing the stop loss price:
There is no fixed price at which a Stop Loss can be set. It differs across stocks. This is mainly since the degree of fluctuation for each stock price will be different. For instance, Stock A’s price may rise or fall by 10% within a month while Stock B tends to move only by 5%. Thus, the Stop Loss for each may vary. While using Stop Loss, it is important to keep the investment duration in mind. Short-term investors mostly have a low threshold, therefore, their Stop losses are normally around 2-5%. Long-term investors tend to set a higher Stop Loss of 10-20%.
Trailing stop loss:
This variant of Stop Loss helps to protect profits. For instance, you buy a stock at Rs 100 and the price increases to Rs. 120. You can then set a Trailing Stop Loss at a fixed amount of Rs. 10 or at 5%. The Trailing Stop Loss will be triggered if the stock falls from Rs. 120. If it touches Rs. 110 or falls by 5% to Rs. 114, the Trailing Stop Loss automatically places a sell order and protects your profits.
You can also use a combination of two Stop Losses to protect your profits and minimise your losses. Suppose you buy a stock at Rs. 100 and set a Stop Loss at Rs. 80 along with a Trailing Stop Loss at Rs. 10. You can also replace the Trailing Stop Loss with another Limit Sell order. This order takes effect in case the stock price touches a high price of, for instance, Rs. 120. Thus, you can limit the risk in your investment portfolio as your losses will be limited.
What are the benefits of stop loss
Here are some of the main benefits of stop loss:
- It provides protection against excessive losses
- It enables investors to ensure better control of their investment
- Investors can use it to monitor multiple deals
- Stop loss is automatically executed, thus eliminating manual intervention each time a stock price fluctuates undesirably
- Easy to implement
- Allows individual investors to decide on the amount of risk they can take
- Promotes discipline
Things to consider while using Stop Loss
Here are some of the important factors to be noted while using stop loss in trades:
- Stop loss can be activated even if there are short-term price movements. The idea, however, is to protect against downside risk. Therefore, it should be set up such that it allows day-to-day price movements in stocks.
- Impulse selling can also be triggered due to a stop loss. If a stop loss is not selected and set up appropriately, it may result in a trade being stopped before it can be profitable.
- New investors may not be able to take the decision on setting stop loss limits. Therefore, it is important to learn more about the concept or consult a financial advisor while setting it up.
- Some brokers may also charge for using the stop loss option as part of the overall brokerage. This can result in additional cost and reduced profits through trades.
A Stop-loss strategy is mainly used to avoid additional losses if the trend is against the trade decision by exiting the trade at a price point automatically. It is a good option for day traders to use and limit losses after a certain price movement.
In the trailing stop-loss strategy, the threshold price is set, above which it will execute itself and come out of the trade if the price shift may result in losses. However, it is not fixed on a particular number and it changes depending on the trend to ensure minimal risk.
In this strategy, the stop-loss order is placed at a price point at which the stock price trend is expected to rise up from a downward trend.
There is no set rule on the price at which one should set a Stop Loss. Short-term traders tend to use Stop Losses of 2-5% whereas Long-term investors may set Stop Losses of 10-20%. It all depends on your risk tolerance.
A fixed stop loss is an order triggered in case a predetermined price is reached. Fixed stop loss can be timed as per the type of trade.
Yes, you can buy a stock and set a stop loss at the same time. Investors often enter the market on a limit order and use a protective stop to manage risks.