What is Stop-Loss Order and How It Works?
Sometimes, a person may use cautious risk management techniques instead of trading and investing. Instruments that serve as risk management tools include stop-loss orders, which are likely the most effective. This writing aims to expound the purpose of stop-loss orders for traders, show how to place the order and recommend a stop-loss order placement to turn trading into a profitable venture.
What is a Stop-Loss Order?
A stop-loss order is an instruction from you to your broker regarding the sale of a security if it reaches a specified, pre-determined price below the current market price. This helps to limit potential losses on a trade or an investment.
Think of a stop-loss order as insurance on your investments. If you get insurance to protect your house or car, you take out an order to protect the value of your portfolio from massive falls in price.
Why Use a Stop-Loss Order?
There are several compelling reasons to incorporate stop-loss orders into your trading strategy:
- Loss Limitation: In most cases, markets are volatile, where prices move against you quickly. A stop-loss order provides an automatic mechanism to exit so that such huge losses are avoided.
- Emotional Detachment: Trading can be an emotional rollercoaster. Fear and greed are the very emotions that can cloud your judgment and make you hold onto losing positions longer than you should or make you exit profitable trades far too early. Take the emotions out of the picture, and a stop-loss order will trigger a sell order for execution at the chosen price.
- Time Efficiency: Sometimes, the market may operate on a 24/7 basis. A stop-loss order is still effective even when one doesn't have time to monitor the markets appropriately. It offers peace of mind, knowing your risk is getting managed while you are away.
Types of Stop-Loss Orders
There are two main types of stop-loss orders:
- Regular Stop-Loss Order (or Stop Order): A standard stop-loss order automatically turns into a sell order for your shares at a market price when the stop-price level is reached. A market order would be filled immediately, but the trader would have no control over the price. Along with untimely market regulation, there is a slight chance that you might have a less favourable deal during high volatility.
- Stop-Limit Order: Unlike a limit order, a stop-limit order is placed based on assumptions about future market movements. A limit order initiates when a specific level is reached, either above or below the set price. No matter how much they fluctuate, your shares won't be sold off if they don't reach your maximum price. However, close monitoring is required to see if you can control the price. If the market changes more quickly, your order might not get executed.
Procedure for Placing Stop-Loss Orders
Most online brokerage platforms offer straightforward ways to place stop-loss orders. Here's the general process:
- Accessing Your Order Screen: Log in to your brokerage account and go to where you would like to order the stock or security you intend to protect.
- Selecting Order Type: Choose "stop-loss order" or "stop-limit order," depending on your preference.
- Specifying the Stop Price: Enter the stop price to activate your market order.
- Specifying the Limit Price (for Stop-Limit Orders): Enter the lowest price you're willing to sell your shares for a stop-limit order.
- Quantity: Indicate how many shares you want to sell.
- Review and Submit: Carefully review your order details and submit them to your broker.
How to Use a Stop-Loss Order Strategically
Stop-loss order placement isn't a "set it and forget it" situation. Here are tips on how to use them effectively:
- Technical Analysis: Use support levels, trendlines, moving averages, and other technical indicators to decide what the possible stop-loss price points could be.
- Position Sizing: Consider your overall position size when determining the stop-loss levels. To keep the position from liquidation by regular market activity, wider stop losses could be required.
- Trailing Stop-Loss: You might want to use a trailing stop-loss, which will automatically adjust the stop price higher as the price of security increases. It will lock in gains while protecting the downside.
- Re-evaluation: Revisit and, if necessary, adjust stop-loss orders regularly, corresponding to market change or the shift of your investment thesis.
- Combine with Other Orders: Consider grouping the stop-loss orders with "take-profit" orders that allow you to leave a trade automatically when a particular profit target is achieved, further systemising your trading strategy.
Important Considerations
While incredibly useful, stop-loss orders come with a few things to keep in mind:
- No Guarantee Against Losses: Stop-loss orders help manage risk, but they cannot eliminate it. In volatile markets, prices can "gap" through your stop-loss, effectively putting you out at a worse level than you had anticipated.
- Slippage: In particular, at highly volatile times, such as those referred to by the preceding paragraph, your sell order might get executed at a price some fraction different from that which you have previously set as your stop price.
Example To Understand: How Do I Place a Stop-Loss Order
Consider investing a net value of Rs. 50 as a quick investment in the XYZ Company with 100 shares at face value. You aim to keep the risk of losing the whole amount to not more than 10%. Here's how you could place a stop-loss order
Calculate Stop Price: A detrimental 10% fall requires a stop price of Rs.45(Rs.50 – 10%).
Type: Decide between a stop-loss or stop-limit order, determining whether the chosen one suits your case.
Submit Order: Put your stop-loss order through your broker so that the details you have provided at the top will be considered.
Should XYZ fall from Rs. 45, your stop-loss order will buy shares at the market price (the regular stop-loss) or the next available at or above your limit price (the stop-limit).
Conclusion
Stop-loss orders are an integral tool for a trader or investor's risk management. Knowing how to set the stop-loss order allows you to manage your investment outcomes precisely; therefore, you should not be concerned about portfolios regardless of their direction. Always remember that risk is a constant factor when trading and investing. Although stop-loss orders cannot be the sole source of all the profits, they still provide specific protection from probable losses.
Can a stop-loss order be placed for a futures contract?
Stop-loss orders can be placed for various financial instruments, including futures contracts. The process is similar to placing a stop-loss order for stocks or other securities, but there may be slight variations depending on the specific futures exchange or broker.
Can a stop-loss order be used for short positions?
Yes, stop-loss orders can be used for both long and short positions. For a short position, a stop-loss order would be placed above the current market price, as the goal is to buy back the shorted shares if the price rises above a certain level to limit potential losses.
Can a stop-loss order be modified or cancelled once placed?
In most cases, stop-loss orders can be modified or cancelled as long as they have not been executed. However, it's important to check your broker's policies and procedures for modifying or cancelling stop-loss orders, as there may be specific requirements or limitations.
Can I modify or cancel a stop-loss order after placing it?
Yes, you can modify or cancel a stop-loss order if it has not been executed. Check with your broker for their specific policies and procedures.
Is it better to use a stop-loss order or a trailing stop-loss order?
A trailing stop-loss order can be more effective for locking in profits as it adjusts the stop price higher as the security price increases. However, a regular stop-loss order may be more suitable for trades with a specific target price.