Stop-Loss Order: What It Is, Importance & Limitations | Research 360 by Motilal Oswal

What is a Stop-Loss Order?

10 Sep, 2024 15:04pm
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To become a successful trader, you need to gain theoretical and practical knowledge of various aspects of trading. Technical analysis and trading strategies are, of course, extremely important. However, you must also be familiar with the basics of practical trading. This includes the different types of trading orders that you can place using your trading account — such as market, limit, stop-loss and after-market orders. 

Stop-loss orders, in particular, are crucial for risk management in stock and derivatives trading. In this article, we discuss what a stop-loss order is, how it works, what the many stop-loss types are and more. 

 

What is a Stop-Loss Order?

A stop-loss order is a type of trading order that is designed to limit the potential losses on a trade. It is an instruction that tells your stockbroker to close your open position in the market when the price of the stock reaches a specific level. The position is typically closed by initiating an order that is the opposite of your current trade in the market. 

This means that if you have a long position open, a sell order is placed to close the trade and limit your loss. Conversely, if you have a short position open, a buy order is placed. So, in the simplest terms, a stop-loss order is an instruction to sell or buy a stock or security when it attains a specific price. 

How a Stop-Loss Order Works

The particulars of a stop-loss order must be specified at the time of placing the order itself. This is because a stop-loss trading order is automatically executed when the stock reaches specified price levels. 

For example, say a company’s shares are now trading at Rs. 100 and you expect the stock price to increase. So, you take a long position, buy 100 shares of the stock and wait for the price to rise. However, the market is quite volatile and the risk of the stock price falling is moderate. To protect your capital if the price dips, you can place a stop-loss order at any price below Rs. 100. Say you can withstand a maximum loss of Rs. 1,000 (or Rs. 10 per share). So, you set the stop-loss limit at Rs. 90. If the share price drops to this level, your shares will automatically be sold at the market price (since this is not a stop-loss limit order). 

As you can see, by closing your position when the stock hits the stop-loss trading limit of Rs. 90, this type of order limits your loss to around Rs. 1,000. Without this risk management measure in place, you may lose a lot more in fast-moving markets, where the price may drop steeply and rapidly. Before you can place a new sell order, the price may drop further, leading to higher losses. 

 

Types of Stop-Loss Orders

Based on the type of stop-loss trigger in place and the price at which the resulting new order is set up, you can find the following types of stop-loss orders.

  • Stop-Loss Market Order

Here, the new order that is placed automatically when the stop-loss limit is breached is a market order. This means that the new order will be executed at the prevailing market price. You can use this type of stop-loss order in a relatively stable market, because the price may not change drastically by the time the order is triggered. In other words, the slippage is reduced. 

  • Stop-Loss Limit Order

In this type of stop-loss order, the new order placed when the price trigger occurs is a limit order. This means that you have to enter the stop-loss price as well as the limit price when you are placing the stop-loss order. Once the stock price hits the limit for stopping the loss, the new order limit order will be triggered. However, it will be executed only at the limit price specified. This makes the stop-loss limit order better suited for volatile markets. 

  • Fixed Stop-Loss Order

This type of stop-loss order comes with a predetermined price limit for triggering the position closure. The stop-loss limit does not change or alter based on the market movements. This is the most common way of limiting the losses in a volatile or dynamic market segment. It is also easier for beginners to understand this type of stop-loss order as there are no changes involved. 

  • Trailing Stop-Loss Order

A trailing stop-loss order is a unique type of stop-loss order that helps you limit your losses and lock in your profits as needed. You must set it at a fixed percentage or amount away from the current price. For long positions, it is set below the current stock price. For short positions, the trailing limit is placed above. If the price moves in your favour, the trailing stop also moves proportionately. However, if the price moves unfavorably by the predetermined amount or percentage, the position automatically closes.

For example, say you purchase a company’s shares at Rs. 100 and set a trailing stop-loss limit at Rs. 95 (i.e. Rs. 5 below the current price). If the stock price rises, the trailing stop will also rise accordingly — always remaining Rs. 5 below the current market price. However, if the stock price hits Rs. 95, the stop-loss will be triggered and a sell order will be initiated to cap your losses as planned. 

 

Advantages and Disadvantages of Using a Stop-loss Order

A stop-loss order has both advantages and disadvantages. Let us look into the benefits of these orders before discussing their limitations. The main advantages of stop-loss orders include the following. 

  • Efficiency

Stop-loss orders work even when you are not actively monitoring the market. This constant vigilance ensures that you are protected against sudden price drops that might occur when you are unable to watch your investments closely.

  • Strategy Flexibility 

You can adjust your stop-loss orders as market conditions change or as your trading goals evolve. This adaptability allows you to fine-tune your risk management strategy by tightening or loosening your stop levels based on new information.

  • Capital Preservation

By limiting the downside risk, stop-loss trading helps preserve your trading capital. This is crucial for long-term success in trading because it allows you to stay in the market and potentially recover from losses more quickly than if you had suffered larger drawdowns.

  • Psychological Benefits

Stop-loss orders can significantly reduce stress and anxiety associated with trading. Knowing that you have a safety net in place can give you peace of mind and allow you to focus on analysing opportunities instead of constantly worrying about potential losses.

Stop-loss orders also have a few limitations that you should know of, such as the following:

  • Premature Exits

Stop-loss in the share market can trigger sales during short-term price fluctuations. So, investors may exit positions prematurely. This can result in unnecessary losses if the stock rebounds quickly. Traders may potentially miss out on long-term gains due to temporary market volatility.

  • Uncertainty of Order Execution 

In fast-moving markets, there is no guarantee that a stop-loss order will execute exactly at the specified price. The actual sale price might be lower, especially during rapid price declines, thus leading to larger losses than anticipated.

  • Increased Transaction Costs

Frequent triggering of stop-loss orders can lead to higher transaction costs because each sale incurs fees. This can erode the net profits, particularly if you are an active trader or if you use tightly set stop-loss levels in volatile markets.

 

Importance of Stop-Loss Order

Stop-loss in the share market is crucial for risk management because these orders automatically trigger a sale (or a purchase) when the stock price reaches a predetermined level. This has the effect of limiting or capping your losses and ensuring that they are within your risk capacity and tolerance limit. 

For instance, if you buy a stock at Rs. 50 and set a stop-loss limit at Rs. 48, your position will be closed if the stock price falls below this level. This will prevent further losses, even if the downturn continues. Such an order can be particularly useful in volatile markets where stock prices can change rapidly. 

For example, say you hold shares in a technology company that is due to announce its quarterly earnings results today. If the results are disappointing and the stock price plummets, stop-loss trading can protect you from significant losses before you even have a chance to react manually.

Stop-loss orders also help you cultivate and maintain trading discipline since it removes emotion from your trading decisions. It's common for investors to hold on to losing positions, hoping for a recovery. A preset stop-loss takes this decision out of your hands and enforces a disciplined exit strategy. This can be especially beneficial if you are a new investor or trader struggling with understanding when to cut your losses.

 

Conclusion

To find the ideal price for stop-loss trading, you must be aware of the nearest support and resistance levels. Additionally, you also need to know the RSI and other technical indicators and be aware of how the stock price may move in the next few trading sessions. 

The Research 360 platform from Motilal Oswal can help you make smarter trading and investment decisions — thanks to crucial insights about every listed stock, like its technicals, average price target, high and low estimates and more. These details, combined with in-depth technical analysis, can help you determine the ideal price for stop-loss in the share market or any other market segment you may be trading in. 

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