Stop-loss Order

Discover the ins and outs of stop-loss orders, from activation triggers to execution strategies.
Stop-loss Order
3 mins
21 November 2023

What is a stop-loss order?

A stop-loss order is a risk management tool employed by investors and traders to automatically sell a security at a predetermined price, mitigating potential losses. It instructs a broker to buy or sell at the market when a security reaches a certain price known as the stop-loss price.

For instance, if a stock is purchased at Rs. 100 and the loss is to be limited at Rs. 95, an order can be placed to sell the stock as soon as its price reaches Rs. 95. Such an order is known as a ‘Stop Loss’ as it aims to prevent a loss exceeding the predetermined risk.

Stop-loss acts as a safety net, executing a market order when the asset's value reaches or falls below the specified stop price.

How a stop-loss order works?

  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.

Types of stop-loss orders

  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

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

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

  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

  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.

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.

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This content is for educational purpose only.

Investment in the securities involves risks, investor should consult his own advisors/consultant to determine the merits and risks of investment.

Frequently asked questions

What is a stop-loss order vs a limit order?

A stop-loss order is a tool to limit losses by automatically selling a security when it hits a predetermined price. In contrast, a limit order sets a specific buying or selling price, ensuring execution at that price or better but without the automatic trigger of a stop-loss.

Should an investor set a stop-loss order?

Setting a stop-loss order is advisable for investors aiming to manage risk. It provides a safety net, automatically selling a security at a predetermined price to limit potential losses, fostering a disciplined approach to trading.

What is the use of a stop-loss order?

A stop-loss order is used to minimise losses in trading. It acts as an automated sell instruction, triggered when a security's price reaches, or falls below a specified level, protecting investors from significant downturns and emotional decision-making.

What are the two types of stop-loss order?

The two types of stop-loss orders are fixed stop-loss and trailing stop-loss. Fixed stop-loss is triggered at a specific pre-determined price, while trailing stop-loss adjusts with market movements, protecting gains and limiting losses dynamically.

What are the limitations of using stop-loss orders?

The limitation of using stop-loss orders lies in their vulnerability to market volatility and potential false triggers. In fast-moving markets or during extreme events, orders may be executed at prices different from the intended stop price, leading to unexpected outcomes. Investors should be aware of these limitations and incorporate them into a broader risk management strategy.

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