What Is a Stop-Loss Order?
A stop-loss order is placed with a broker to buy or sell a specific stock once the stock reaches a certain price. A stop-loss is designed to limit an investor’s loss on a security position. For example, setting a stop-loss order for 10% below the price you bought the stock will limit your loss to 10%.
Stop-limit orders are similar to stop-loss orders. However, as their name states, there is a limit on the price at which they will execute. There are then two prices specified in a stop-limit order: the stop price, which will convert the order to a sell order, and the limit price. Instead of the order becoming a market order to sell, the sell order becomes a limit order that will only execute at the limit price.
How Stop-Loss Orders Work
Traders or investors may use a stop-loss order to limit losses and protect profits. By placing a stop-loss order, they can manage risk by exiting a position if the price for their security starts moving in the direction opposite to the work they’ve taken.
A stop-loss order to sell is a customer order that instructs a broker to sell a security if its market price drops to or below a specified stop price. A stop-loss order to buy sets the stop price above the current market price.
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 helpful for investors who want to provide the position a pre-set amount of time to profit before moving on to 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 the 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 to an overall increase in market valuation.
Advantages of the Stop-Loss Order
The most important benefit of a stop-loss order is that it costs nothing to implement. Your regular commission is charged only once the stop-loss price has been reached and the stock must be sold. One way to think of a stop-loss order is as a free insurance policy.
Stop loss helps to automate your selling of stocks, so 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.
An investor needs to detach himself/herself from the market emotions. Stop loss helps you to stick to your financial plan/strategy and promotes disciplined trading.
No matter what type of investor you are, you should be able to easily identify why you own a stock. A value investor’s criteria will be different from the criteria of a growth investor, which will be different from the criteria of an active trader. No matter the strategy, it will only work if you stick to it. So, if you are a hardcore buy-and-hold investor, your stop-loss orders are next to useless.
At the end of the day, if you are going to be a successful investor, you have to be confident in your strategy. This means carrying through with your plan. The advantage of stop-loss orders is that they can help you stay on track and prevent your judgment from getting clouded with emotion.
Finally, it’s important to realize that stop-loss orders do not guarantee you’ll make money in the stock market; you still have to make intelligent investment decisions. If you don’t, you’ll lose as much money as you would without a stop-loss.
Disadvantages of Stop-Loss Orders
The main disadvantage of stopping loss is that it can get activated by short-term fluctuations in stock price. Remember, the key point 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. Setting a 5% stop-loss order on a stock that has a history of fluctuating 10% or more in a week may not be the best strategy. You’ll most likely just lose money on the commission generated from the execution of your stop-loss order.
There are no hard-and-fast rules for the level at which one should be placed; it depends on your investing style. An active trader might use a 5% level, while a long-term investor might choose 15% or more.
Another thing to remember is that once you reach your stop price, your stop order becomes a market order. So, the price you sell may differ from the stop price. This is especially true in a fast-moving market where stock prices change rapidly. Another restriction with the stop-loss order is that many brokers do not allow you to place a stop order on certain securities like OTC Bulletin Board stocks or penny stocks.
The only risk involved with using a stop-loss tool in trading is the potential risk of being stopped from 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, limiting profit potential.
Investors need to decide which price to set, which could be tricky. You can take the help of financial advisors, but that won’t be for free. Sometimes your stock broker can charge for using stop-loss orders, which 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 minimizing 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 their position for an extended period to earn higher profits, a price variation can lead to significant capital losses.
Limitations
Stop-loss order is not based on market analysis and is designed to mitigate the risk level by monitoring investors’ losses. Hence, the period of any adverse fluctuation cannot be predicted. A rigorous fall in 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 do individuals fail to recover the principal amount, but they also lose out on any capital gains.
Another limitation of stop-loss orders is 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 the 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 sign a stop-loss trading order to ensure losses are capped if prices move unfavorably.
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