What is Stop Loss?
When you invest in a stock, you anticipate it will increase in value. However, a number of causes can lead to short-term market fluctuations. To protect against a significant change in the market price of a stock a stop loss is beneficial. You will instruct your broker to automatically sell the shares at a specific price using the Stop Loss feature. Typically, this stop loss price is less than the purchase price of the stocks. You can cut your losses in this manner without having to monitor the stock directly. These are known as “Cover Orders.”
For instance, you are buying a share at a price of Rs 248. Now you anticipate it to increase up to Rs 266 in the next 3 months. However, the prices can move down as well. So to protect against significant losses, you can benefit from this feature. You will instruct your broker to sell these stocks as soon as the market price hits Rs 240. This way you restrict your losses to only Rs 8 per share (Rs 248 – Rs 240).
This approach is used to prevent further losses by automatically ending the transaction at a specific point when the trend is against the trading decision. For day traders who wish to avoid losing money after a price decrease, it’s a great option and a personal preference. Swing low and high orders are riskier. Moreover, it may result in higher losses than usual. Hence, traders as well as investors use these orders frequently to limit future losses.
Types of Stop Loss Orders
- Sell Stop Order – It is beneficial to stop loss and make profits from selling a stock at a specific price. The stop price will be lower than the current market price of the stock.
- Buy Stop Order – The order is to buy a stock and is usually beneficial for short selling transactions. The stop price will be higher than the current market price of the stock.
- Trailing Stop Order – It offers a net profit and protection to the investor. A trailing stop-loss order acts as a barrier against an unanticipated downward trend in the share price.
This order is based on a percentage of the overall price. It includes a sell instruction if the market falls below the demand level. On the other hand, if the stock price increases then the trailing order changes and reflects the increase in market valuation.
How To Calculate Stop Loss Price?
To calculate the stop loss price every trader must understand two aspects. Firstly, what is the loss or extent of loss that they are willing to take? Secondly, which technical level suits their objective? The following are the approaches that can help a trader in calculating the stop loss price:
1. Technical Support or Technical Resistance
The Technical Support / Technical Resistance strategy is the most common method for determining the stop loss. While slightly more difficult, this is also more scientific. This strategy is used by the majority of seasoned intraday traders, but it requires an expert understanding of how to read charts. The stop loss is positioned above the resistance for sell positions and beneath the support for purchase positions.
2. Moving Average Approach
The first step for a trader is to identify a reference point on the long-term moving average. For this purpose, a trader can use either exponential moving averages (EMA) or simple moving averages (SMA). As soon as you identify and freeze the moving average, you need to set the stop loss. Now, set the stop loss slightly below the moving average level for buy positions. Next, for sell opportunities set slightly above the moving average line.
3. Percentage Approach
For establishing stop losses, intraday traders frequently use the percentage method. Here, to calculate the allowable loss, the traders use a percentage approach. For instance, if you buy shares of a company at Rs. 1800 and set a 1% stop loss, your buy position’s stop loss will be set at Rs. 18 lower, at Rs. 1782. If a trade goes wrong, you can only lose up to that amount. While determining stop losses, take brokerage and statutory fees into account as well.
Advantages and Disadvantages of Stop Loss Orders
- Easy To Implement: The fact that there are no additional fees associated with implementing an order is its most significant advantage. Once the share reaches the stop-loss price, you can sell it at the standard commission. One way to think of an order is like a free insurance policy for your stock investments.
- Saves Time: When you place these orders, you are relieved of the daily monitoring of a stock’s performance. This convenience is especially useful if you lack the time to keep track of your stocks for a long period of time.
- Informed Decision Making: The orders can assist in shielding your judgment from emotional factors. Stocks have a way of making people “fall in love.” For instance, people can continue to hold onto the false notion that a stock would turn around if they give it another chance. In actuality, the delay can only result in further losses.
Moreover, it is critical to understand that orders do not ensure that you will make money in the stock market; you still need to make wise investment choices. Failure to do so will result in losses equal to those that would occur in the absence of a stop-loss.
- Short Term Perspective: The main disadvantage of stop-loss orders is that they could be activated by a brief change in the price of a stock. The idea is to select a percentage is to minimise downside risk while still allowing daily stock fluctuations. It might not be a good idea to place a 7% stop-loss order on a stock with a history of weekly volatility of 11% or more. Most likely, the commission earned from carrying out such an order will result in a loss for you.
- Higher Fluctuating Markets: Your stop order turns into a market order if you reach your stop price. The selling price and the stop price could be different. This is especially true in a market that fluctuates often and where stock prices vary extensively.
Difference Between Stop Loss Order and Limit Order
- A limit order is an order that a trader or investor places to buy or sell at a specific price. Whereas, a stop loss order is a direction to a broker to buy or sell a stock when the price reaches a specific trigger price.
- The intent of a limit order is to maximise profits from the trade. On the other hand, the objective of a stop loss order is to minimise potential losses.
Frequently Asked Questions
A fixed stoploss order is an order to a broker which is triggered when a predetermined price is hit or reached in the stock market.
Yes, stoploss automatically sells the stocks. It is a standing instruction for a broker to buy or sell the stocks if the price reaches a specific price.
A stoploss order is like insurance against any adverse fluctuation. The basic feature or advantage is to limit the losses. Hence, a trader or investor must initiate a stoploss order at the time of entering the trade or investment.
In the case of a trailing stop loss, the stop parameter is on the basis of a trailing change. This trailing change is actually the reduction of stock price over a period.
There are different methods to determine the stop price. You can use the percentage approach, moving average method, or technical resistance method.
Yes, you can buy stock and set a stoploss at the same time.
Yes, a stoploss can fail. Illiquid equities might not have any buyers, preventing the stoploss order from activating. Secondly, if trading is interrupted for some reason.
The price at which the trade is stopped and a loss is booked is known as the trigger price. Its purpose is to safeguard the trader.
Yes, you can use stoploss for intraday trading. For intraday trading, a trader has just 1 day to close their open trading positions. Hence, such an order may lead to an increase in risk.