Stop-loss order: an effective way to limit the loss due to the fall in the share price
To buy or sell a security when its price falls below a certain level, you must place a stop-loss order with your broker. When it comes to stop-loss orders, they are used to limit an investor’s loss on a safe basis. These orders are distinct from stop-limit orders, which are used to limit gains.
As soon as a stock goes below the stop price, it becomes a real order and it is executed at the next open market rate. As an illustration, a trader can buy a stock and set a stop-loss order 10% below the purchase price.
If the stock is low, the buy order will be activated and the stock will also be sold as a purchase order.
While most investors think the order protects a long-term investment, it can also protect a short-term investment, in which case protection is bought if the price goes above a certain level.
Understanding the stop-loss order
Traders and investors may put more emphasis on using an order to protect their earnings. Since it becomes a command, the risk of a command not being executed is removed. When the value goes below the stop price, a stop-limit order is triggered; however, the order may not be executed due to the value of the limit section of the order.
If a stock unexpectedly falls below the stop price, using the stop-loss can be risky. The order would go into effect and the stock would be sold at the next available price, whether or not it was trading well below your stop-loss threshold.
An order to sell something refers to the client asking the broker to do so if the price of the security falls below a certain threshold. The stop price is just above this amount in a very bullish order.
Stop-loss order example
A trader buys 100 shares of XYZ for ₹100 and places a stop-loss order at ₹90. Over the next three weeks, the stock price falls below ₹90. The trader’s order is executed and the position is sold for ₹89.95 to finalize the transaction.
A trader buys 500 shares of ABC Corp. for ₹100 and places a new stop-loss order at ₹90. Due to the company’s dismal financial results, the stock price fell by more than half. For this reason, the transaction is executed at a price of ₹49.50 when the market reopens, triggering the stop-loss order.
Be sure to use the stop-loss order
When weighing the pros and cons of buying a stock, it’s easy to overlook some key factors. One of these aspects could be the order in which things are done. A purchase order, when used correctly, can have a huge impact. This tool is accessible to almost everyone.
Advantages of the stop-loss order
A command has the major advantage of being entirely free to implement. You will only be charged your standard commission if the stop-loss price has been reached and the stock needs to be sold. One way to think of a purchase order is as a form of unlimited insurance.
A purchase order also has the advantage of removing emotional factors from the decision-making process. Actions tend to make people “in love”. An illustration of this would be the myth that if people gave an underperforming stock one more chance, it would backfire. In fact, if this delay persists, the damage could get worse.
Any investor should be able to quickly and easily identify why they own a particular asset. The standards of a value investor differ from those of a growth investor, which may differ from those of an enthusiastic trader. Whatever the strategy, it will only work if you stick to it. Stop-loss orders are almost useless if you are an avid buyer and holder of stocks.
Ultimately, if you want to be a successful investor, you have to have confidence in your plan. This requires following your plans. Stop-loss orders have the advantage of allowing you to stay the course while preventing your judgment from being affected by emotion.
Finally, keep in mind that stop-loss orders do not guarantee a trading profit; it is still necessary to make judicious investment choices. If you don’t, you will incur losses equal to or greater than you would in the absence of a stop-loss, but at a slower rate.
Stop-loss orders are also a way to lock in profits
Stop-loss orders have long been considered the simplest approach to preventing losses. However, this technology can also be used to secure income. Stop-loss orders can be used as a “trailing stop” in this situation. The stop-loss order is set at a percentage level below the current market value (not the value at which you buy it). As the stock price changes, the stop-loss amount also changes.
It is essential to remember that if the price of a stock increases, you have accrued an unrealized profit; you won’t have the upper hand until you sell. Using a trailing stop gives you the freedom to let profits run while providing at least some monetary benefit.
Let’s take the XYZ example from earlier and suppose you place a trailing order 10% below that price and the stock rises to Rs.30 within a month of your trailing order triggering. Your trailing stop order would then be locked at Rs.27 per share (Rs.30 – (10 percent x Rs.30) = Rs.27).
Because it’s the lowest price you can get, even if the stock drops suddenly, you won’t lose money. It is important to keep in mind that the purchase order is always a market order; it is simply inactive until the trigger price is reached. Therefore, the value at which your sell actually occurs can fluctuate significantly from the desired trigger price.
Disadvantages of the stop-loss order
If you use a stop-loss order, you won’t have to check the performance of the stock daily. This benefit is especially useful if you’re going on vacation or can’t keep an eye on your wallet for an extended period of time.
However, a short-term change in the stock price could trigger the stop price. The idea is to choose a stop-loss percentage that allows the price of a stock to fluctuate daily while avoiding downside risk as much as possible. The ideal technique may not be to set a 5% stop-loss order on a stock with a history of at least 10% fluctuation in a week. Stop-loss orders are designed to prevent you from making more money than you lose when they are executed.
Stop-loss levels are not immutable; rather, they are based on your personal investment strategy. It is possible for active traders to set their stops at 5%, while long-term investors set their stops at 15% or more.
Another thing to keep in mind is that your stop order will become a market order once you hit your stop price. Selling at a price significantly above or below the stop price is possible. When the stock market moves rapidly, this point becomes much more important. Another limitation of the stop-loss order is that many brokers do not allow you to place a stop loss order on certain assets like OTC Bulletin Board stocks or penny stocks.
Stop-limit orders carry additional dangers. These orders may guarantee a price limit, but the trade cannot be completed by the market participant.
Although a stop-loss order is a simple tool, many investors do not use it. Almost any investment style can benefit from using this instrument, whether to avoid major losses or to secure profits. Stop-loss orders are like insurance policies – you hope you never need them, but it’s comforting to know you’re covered.
Follow MintGenie for more stories like this.