How a stop-loss order works?
A stop-loss order works in the following manner:
1. Setting the stop price
Investors decide on a stop price based on their risk tolerance, market analysis,or technical indicators. This price represents the threshold at which they are willing to sell the asset to limit potential losses.
2. Placement with a broker
Once the stop price is determined, the investor places a stop-loss order with their broker. This can typically be done through online trading platforms or by contacting the broker directly.
3. Monitoring market conditions
As the market fluctuates, the stop-loss order remains dormant until the security's market price reaches or falls below the specified stop price. Investors need to monitor market conditions regularly to assess whether the stop-loss order might be triggered.
4. Automatic execution
When the market price of the security reaches or falls below the stop price, the stop-loss order is automatically triggered. At this point, the stop-loss order is converted into a market order, and the broker executes the sale of the asset at the best available market price.
5. Market order execution
The stop-loss order, now transformed into a market order, is executed at the prevailing market price. It is important to note that the actual execution price may differ from the stop price, especially in fast-moving markets or during periods of low liquidity. This phenomenon is known as slippage.
Example
To illustrate the concept of a stop-loss order, let's consider an example. Suppose Rahul purchases 500 shares of Reliance Industries at Rs. 100 per share, investing a total of Rs. 50,000. If the share price starts to decline rapidly, Rahul can place a stop-loss order with his broker to automatically sell the shares if the price falls below Rs. 80. By setting this stop-loss, Rahul can limit his potential loss to Rs. 20 per share.
Types of stop-loss orders
There are different types of stop-loss orders, which are explained below:
1. Fixed stop loss
As the name suggests, a fixed stop-loss order is a type of stop-loss order where the stop price is set at a fixed level, typically a percentage below the market price. Imagine you just made a trade, and with a fixed stop loss, you have set a safety net at a certain price. It is not just about the price; you can also set a time limit. This is handy for those who want to give their investment some time to grow before moving on to the next one. But here is the catch – only use time-based stops if your investment is flexible enough to handle significant price swings. This smart move ensures your investment can weather the storm, no matter how unpredictable the market gets.
2. Trailing stop-loss order
The main difference between a trailing stop and a fixed stop loss is that the former moves along with the price whenever it goes in our favour and freezes when it goes against us, while the latter is always fixed at the level we have established, regardless of the movement of the asset, and will jump when its price reaches that level. A trailing stop is more flexible than a fixed stop-loss order, as it automatically tracks the stock’s price direction and does not have to be manually reset like the fixed stop-loss.
If the market takes a dip and the price falls below the set level, the sell order kicks in. But here is the cool part – if the market goes up and prices rise, the trailing order adjusts, following the market's overall value.
Let us break it down: If your trailing stop-loss order activates when the security's price drops below 10% of the market value, and you bought at Rs. 100, it kicks in at Rs. 90 to protect your investment. Now, if the market loves you, and the share price goes up to Rs. 120, the trailing order, set at 10% of the current market price (Rs. 108), stays by your side. If prices start to fall after reaching Rs. 120, the stop-loss order kicks in at Rs. 108, letting you enjoy a profit of Rs. 8 on your investment.
In simple terms, the trailing stop-loss order is like a watchful friend, adjusting to the market and making sure you benefit from your clever investment moves.
Differences between stop-loss order and market order
Here are the major differences between stop-loss orders and market orders:
Differences
|
Stop-loss order
|
Market order
|
1. Purpose
|
Primarily used for risk management, protecting investments.
|
Executed for immediate buying or selling at the market.
|
2. Activation
|
Triggered when the market reaches/falls below a specified price, converting to a market order.
|
Executed immediately at the best available market price.
|
3. Execution speed
|
Execution follows trigger conditions and may not be immediate.
|
Immediate execution at the prevailing market price.
|
4. Control over execution price
|
Investors have more control over the execution price, but it is not guaranteed.
|
Guarantees execution but lacks control over the exact price.
|
5. Flexibility
|
Offers flexibility for investors to set different stop prices based on risk tolerance.
|
Less flexible, prioritising speed over price control.
|
Differences between limit order and stop-loss order
The following are the major differences between limit orders and stop-loss orders:
Differences
|
Limit order
|
Stop-loss order
|
1. Purpose
|
Executed at a specific price or better, aiming for a favourable entry/exit point.
|
Triggered to sell a security when its price hits/falls below a specified level, primarily for risk management.
|
2. Activation
|
Activated when the market reaches the specified limit price or better.
|
Triggered when the market reaches/falls below a pre-determined stop price.
|
3. Execution price
|
Guarantees the specified price or better but does not guarantee execution.
|
Converts to a market order and is executed at the best available price once the stop price is reached.
|
4. Risk management vs. price control
|
Emphasises price control, allowing investors to specify the exact price.
|
Primarily used for risk management, automating selling to limit potential losses.
|
5. Market conditions
|
May not be immediately executed if the market does not reach the specified price.
|
Triggers a market order and is executed immediately when the market reaches/falls below the stop price.
|
6. Direction of order
|
Can be set for both buying and selling.
|
Typically used for selling to limit losses.
|
Advantages of using a stop-loss order
Let us now look at the benefits of using a stop-loss order:
1. Risk mitigation
One of the primary benefits is risk mitigation. Stop-loss orders act as a protective shield, automatically selling a security when its price hits a predetermined level, limiting potential losses for investors.
2. Emotional discipline
Stop-loss orders help investors overcome emotional decision-making during market fluctuations. By setting predefined exit points, these orders enforce discipline and reduce the impact of impulsive actions driven by fear or greed.
3. Automated execution
The automation of selling processes ensures timely execution without the need for constant monitoring. This is especially advantageous in fast-paced markets or for traders who may not be able to closely track their investments.
4. Peace of mind
Investors can experience greater peace of mind knowing that there is a predetermined plan in place to limit potential losses. This confidence allows for a more rational and systematic approach to trading.
5. Flexibility and customisation
Stop-loss orders offer flexibility as investors can customise them based on individual risk tolerance, market conditions, and specific investment strategies.
Disadvantages of using a stop-loss order
Stop-loss orders also have certain disadvantages, which are highlighted below:
1. Market volatility impact
In highly volatile markets, stop-loss orders may be triggered more frequently, leading to increased trading costs and potential slippage. Sudden price fluctuations can result in executions at prices significantly different from the stop price.
2. False triggers
Market noise or short-term price fluctuations can trigger stop-loss orders even if the overall trend is positive. This may result in premature selling and potential missed opportunities for profit.
3. Gap risk
In the event of market gaps, such as during after-hours trading or due to significant news events, stop-loss orders may be executed at prices substantially different from the intended stop price.
4. Overreliance on automation
Depending solely on stop-loss orders for risk management may lead to overreliance on automation. Investors should complement stop-loss orders with a comprehensive understanding of market conditions and periodic reviews of their investment strategy.
Importance of stop-loss order
In reality, not every investor can closely and continually track market movements. This is where stop-loss orders can be incredibly effective in curbing losses. These can be an efficient mechanism for traders with a low-risk appetite who want to maximise profits but limit exposure to market volatility.
Stop-loss orders are also helpful for investors to exit the market in a timely manner, as a continued rise or fall in a security’s price could lead to significant losses.
Limitations
Despite its crucial importance for investors in the financial market, you must understand that stop-loss orders are not predicated on technical or market analysis. They are simply put in place to mitigate the risks and potential losses for traders. This means that the actual market fluctuation cannot be determined or understood through a stop-loss order. For example, suppose a stock experiences a sharp temporary decline in its price based on market speculations. In that case, a stop-loss order may lead to high losses, as holding the position would ideally be the better strategy here.
Another drawback of stop-loss orders is related to the timing of selling securities. During periods of intense selling pressure, when there are few buyers in the stock market, stop-loss orders may not execute at the set limit price. This situation can lead to significant losses for investors that exceed their intended limits.
Overall, stop-loss orders can help you manage volatility and investment risks but may not fully protect you against sudden market crashes. They can be, however, quite useful to investors with a low-risk appetite who primarily aim to limit losses if prices decline unexpectedly.
Conclusion
Stop-loss orders act as a shield, protecting our investments and helping us make smart decisions even when the market gets bumpy. By integrating stop-loss orders into a well-thought-out investment strategy, investors can strengthen their portfolios against unforeseen market fluctuations, finding a balance between automation and astute market awareness.
Related Articles:
