When we as trader or investor keeps on placing an order in the stock market, we generally forget one important thing which is of utmost importance in short-term trading and that is Stop Loss. Stop-loss acts as an insurance policy for your trade when the market starts behaving against your expectations. In this article, we will discuss stop loss and what is its significance for a trader in detail.
What is stop loss in the stock market?
As its name suggests, means it stops your losses from widening when the market acts in opposite to your expectations. Every trader wants to book profit but the market does not behave as per their expectations every time. Sometimes the market can turn the opposite so in that case, stop loss acts as an edge of protection to minimize the losses.
Stop-loss is a tool that is used by traders to minimize or limit the losses in a particular trade so as to reduce their risk. It is an advanced system of placing an order in the market where you will exit the market automatically when the price of the stock reaches to a specified level. Stop-loss is a necessary thing for a short-term trader to earn profit.
For example, if you bought a share at 100 Rs and put a stop-loss of 5% that means you are limiting your loss to that 5% only in a case when the market acts against your expectations. Your trade will be automatically squared off if the price of stock touches the level of 95 i.e. (your buying price – 5% of stop-loss).
Who can apply to stop loss?
It acts as an edge of protection for every trader in minimizing loss. The stop-loss level can be adjusted as per the Risk-Reward Ratio by the trader individually. Stop-loss can be used by both traders and long-term investors but it is a must for day traders or intraday traders and short-term positional traders.
Most Brokerage firms do not charge anything extra for this type of stop-loss order so making these orders lucrative for a trader. Actually, Brokerage firms create revenue by the trades and by making these orders lucrative they try to lure traders to put more trades.
How to apply stop loss and where
Before applying stop-loss you must know in which direction you are forecasting the market to go. Suppose you are anticipating the market to further rise then you will be expecting the price of the share you bought to increase as well. So you should put stop-loss at a price level below your buying price so that in case the market turns violent, your loss can be minimized. A trader or investor can apply for a stop-loss order generally in two ways:
Buying first and selling later
It is applied when the market is in the Bullish phase while placing an order of BUY and you put stop loss at a price below your Buying price. Now if the market behaves against your expectations and the price of the stock falls below this stop loss level price, the trade will be automatically executed and you will exit the trade. In this way, your loss will be minimized.
Selling first and buying later
It is applied when the market is in the Bearish phase while placing an order of SELL and you put stop loss at a price above your Selling price. Now if the market behaves against your expectations and the price of stock rises above this stop loss level price, the trade will be automatically executed and you will exit the trade. In this way, your loss will be minimized.
Types of Stop Loss
With the advancement of technology, there is continuous development in the trading system as well. You can put a Stop-loss order in three ways Primary, Break Even, and Trailing stop loss.
Fixed Stop Loss or Primary Stop Loss
Fixed stop-loss is the order which will be triggered as soon as the share price touches the pre-specified price level. This type of order is to be applied immediately at the time of placing your trade. When you are placing a trade in the Bullish market then you will go for a BUY order. After doing a technical analysis of the stock price, you will put Stop-Loss at a price below the buying price.
Suppose you are buying at 500 then your stop loss may be at a price of 480/490 or anything based on your risk appetite and analysis. To avoid or minimize losses, you must know about your Risk Reward Ratio and how to effectively utilize it in a trade. By making use of this ratio you can minimize your losses by putting a nearly accurate stop-loss.
Break Even stop loss
It is applied after some time of the trade execution i.e placing an order of BUY/SELL. It is like a modified form of the Primary stop-loss. Here you can modify your stop loss level if the market price of the stock is going as per your expectations. For example, if you bought a share at 500 and put the Stop Loss at 480, and the market price is rising, then you can change your current stop loss to 500 after placing the order.
The advantage of Break-even stop-loss is that if at all the market goes against your expectations; you will exit the market without loss as the Stop Loss level will be triggered. Here you will only face marginal brokerage costs for the trade.
Trailing Stop Loss
It is like regular Stop Loss order with a difference that it tracks the highest price in the Bullish or rising trend. It is normally used in positional trading when your position hits the target specified as per your Risk-Reward Ratio and risk appetite. A trailing stop-loss will provide capital protection to long-term investors against any market downturn when the market is behaving as per their expectations.
If your stock price hits your targeted price, then your break-even Stop Loss will be converted into a trailing stop loss. It is the procedure of shifting your stop loss in the direction of the market trend once your position hits the target. It is set in the percentage of the total asset or share price you purchased.
Suppose you bought a share at 500 and your break-even Stop Loss was at 480 initially which is now at 500. If your target is 550 and CMP is 555, then there is no need to exit the market at the target price. Instead, you can convert your break-even Stop Loss into a trailing Stop Loss. And to do this, check the candlestick which hits your target on the chart. Now put the new SL at the lowest price among the prior two candlesticks of that candlestick which met the target price.
The advantage of trailing stop loss is that if at all your stop-loss is triggered; you will still exit the market in profit only. But keep in mind that you have to keep shifting your trailing SL to the new level which must be at the lowest price of the two candles prior to the candle which is meeting your new target.
Types of Stop Loss Order
There are mainly two types of order under the category of Stop Loss which you as a trader can put at the stock exchange and these are:
Stop Loss Order (Limit)
Here in this order, you have to enter two different prices, one as trigger price and the second as stop-loss price. Once the price of the stock reaches the trigger price, your order will be sent to the stock exchange and if the price further moves down to the Stop Loss level, then your order will be executed to sell-off. But sometimes because of violent turns, the situation arises when the price reaches to trigger level but does not touch the Stop Loss level and in those cases, your order will remain open. So, in such time you have to face more losses.
Stop Loss Market Order (SL-M)
Here you only provide only one price which is the trigger price and your order will be executed at the prevailing market price once the order is triggered. So in this order, you don’t have to worry about your stop-loss order remaining unfulfilled as the order will be executed at the market price once the trigger price hits.
Advantages of Using Stop Loss Orders
As we have discussed Stop Loss is essential to protect the capital gain and minimize loss, especially for short-term traders. These stop-loss orders have their advantages which are:
Minimize your loss: Using stop-loss orders in trading will surely provide an extra edge of protection to your investment when the market is violent. It will minimize your losses to the pre-specified level or percentage by you only which you decide based on your risk profile.
Good for a new trader: If you are a new trader with minimal knowledge about the trading process, Stop Loss can be a saviour for you. It will protect you from the feeling of the heavy brunt of market fluctuations. So being a new trader, you should at least understand how to use stop loss in every order so as to minimize the losses.
Makes you a Disciplined Trader: Stop loss order promotes discipline in you as a trader because it disassociates you from the market sentiments. It is so because, by these orders, you will remain attached to your trading strategies based on risk-taking capacities.
Allow you to be free: Once you placed a Stop Loss order, it will automatically get executed once the price level touches the trigger or specified level. Hence, you don’t have to be present all the time to monitor the market in real-time and offers you free time to focus on other issues.
Disadvantages of a Stop Loss order
Not everything is perfect and it will carry its own set of advantages and disadvantages and the same is true for Stop Loss orders as well. Some of them are:
Be alert if the order goes unexecuted: There are some situations when you have to remain cautious with your stop-loss order. Sometimes, it happens that you placed a Stop Loss order but your order remains open without execution and in such times you have to bear more losses. For example, you bought a share at 100 Rs and placed Stop Loss at 95, but the market opened with a gap down. Now suppose the market opens at 90 with a gap down, in this case, your order will not be triggered because your SL was at 95 and you have to face the brunt of the market downturn.
Highly sensitive to short-term fluctuations: Stop loss orders are prone to be executed if the market falls to a specified price level and it happens frequently when the market is highly volatile. This also happens when you placed a stop loss with a small margin from that of traded price. In volatile conditions, it happens that the share price drops to a level and then again rises to a new price level. So if you are trading with a small margin, there are chances that your Stop Loss order will get triggered automatically and you will be out of the trade, although the price of stock again rose to a new high.
For example, with a share of 100 Rs and Stop Loss at 95, it can happen that the price goes down to 94 and then again rises to 100+. But it will be of no use for you because your order automatically got triggered when the price touched the price level of 95. So in these cases, you being a trader have to face losses.
How to calculate stop loss
Suppose you want to buy a share of Dhayal Ltd and its Current Market Price is 1000 Rs. Now after taking your risk appetite into consideration, you think that the market price of shares will rise at least up to 1300, so here the reward is 300 Rs.
Reward= Target Price-Buying Price
Now suppose, as per your trading strategy you go for a Risk-Reward Ratio of 3:1, hence your risk appetite will be 100 Rs. So you should place a stop loss at the price by subtracting risk appetite from buying price.
Stop Loss= Buying Price – Risk Appetite
So, here in this case your Stop Loss should be at 900 (1000 – 100) Rs as your Risk appetite is 100 Rs.
So by taking your risk management and reward gain into consideration, you can apply stop-loss accurately as per your trading strategy.
Stop loss for an Investor?
Many long-term investors overlook this concept of stop-loss because the justification they give is that they are not bothered about the short-term fluctuation in the market. Also, it is quite a sensible approach not to exit the trade for short-term market variations, if you are holding the stock for the long term of more than 10 years. But it is the only viable option when you are sure enough about the good performance of the stock in your portfolio in the long term. When the stock is fundamentally strong and you are confident that stock will generate wealth and enhance your personal finances in the long term.
But there are some long-term investors who use stop loss in their investments because they think it is extra protection. So it is totally upon the investor whether he wants to go for the stop-loss order or not for his long-term holdings.
As we have already discussed Stop Loss has its own disadvantages and is less important for a long-term investor, but it is a very important tool for a short-term trader. Because, one big loss in a short-term trade, can eat the profit of the last many successful trades. Also, it is a very important tool for a newbie who doesn’t want to take a large risk at the initial stage. So, he should at least learn how to place stop loss as per his own risk-taking capacity.