What is a Stop-Loss Order?

By Vishweshwar HS,   www.showmytrade.com

The critical factor for a successful trade is to manage the risk. In the stock market, the first essential question to be asked by any investor or trader is how much profit we desire to have for what risk? Stop-Loss order helps to manage the uncertainty in the trade.

Stop-loss orders are placed by traders to limit risk or to lock some profits and take a chance for a big move. The trader can set and modify a stop-loss order in the trading platform. A stop-loss order effectively places a market order once a price threshold is triggered.

Use of Stop-Loss Orders

A stop-loss order can place in the trading terminal. The order executes once the price of the stock in question falls to a specified stop price. Such orders are designed to limit an investor’s loss on a position. Stop-Loss helps a piece of mind (as you can control the expected loss) and one need not monitor the stock price every minute.  

For example

Ms. Akshatha, Bought 100 shares of Biocon at Rs 280, hoping the stock will go to Rs 286/-. She has placed her stop-loss at Rs 278/- (accepting the loss if the price comes down instead of going up). That is, She is taking the risk of Rs 2/- per share for a profit of Rs 6/- per share or Risk-Reward of 1:3 ratio. Here she is limiting her loss for Rs 2/- per share. If she does not put stop-loss, let’s say if the stock price comes to Rs 268, she will make a substantial loss on her trade.

Types of Stop-Loss Order

Time-based Stop-Loss: When a breakout happens and if follow-up buying is not happening in 10-15 mins, apply time-base stop-loss, and close the position (square-off).

Technical-based Stop-Loss:  Here, Stop-loss is applied using the technical parameter. Such as support & resistance, candlestick methods, if false trendline breakout, etc.,

Percentage (%) based Stop-Loss: Disciplined trader fixes a maximum of 1-2% of their capital as Stop-loss per trade. And execute the same stop-loss policy.

Absolute Stop-Loss: Let’s say Rs 5000/- maximum stop-loss per trade. Absolute Stop-loss is expressed in total or actual money terms.

Trailing Stop-Loss Order

Trailing Stop-Loss Order was to advance the stop-loss order to a higher level as the market price rises towards that prevailing trend. Trailing Stop-Loss means trail your Stop-Loss till it trigger.

For example

Ms. Akshatha, Bought 100 shares of SBI at Rs 300, hoping the stock will go to Rs 310/-. She first placed her stop-loss at Rs 297/- (initial stop-loss). If the price moves to Rs 305/-, she moves her Stop-Loss to Rs 303/-. Thus locking the profit of Rs 3/per share. If the price again moves to Rs 308, She trails her Stop-Loss to Rs 306/. Now, if the price reverses its trend and moves down, the trailing stop-loss will trigger, and the position closes with Rs 6/- per-share profit. Thus, ensuring some minimum profit and also taking the chance for a higher profit.

Major Drawback of Stop-Loss

1. Stop-loss order is a money management tool for traders. Still, they do not provide a guarantee against a loss. Sometime, if prices gap down than trigger price, such Stop-Loss won’t be executed.

2. Stop-loss, which is put very tightly, without understanding the volatility of the stock. Very frequently, such stop-loss triggers result in loss. Same way, trailing stop-loss gives very little profit if the stock is very volatile.

Bottom Line

A stop-loss order limits a trader/investor’s potential loss. Using Stop-loss, one can control the accepted risk associated with a trade. The stop-loss triggers a market order to buy or sell once a pre-set price threshold is reached. The advantage of a stop-loss order is less monitoring the stock. Stop-Loss order helps to be a disciplined trader.

Related Articles:

What is Intraday or Day Trading?

What is Positional Trading?

What is Swing Trading?

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