What is Stop Loss in the share market?

Introduction

Investors place a stop-loss order with a broker to sell a specific stock once it reaches a certain price. A stop-loss is designed to limit the investor’s loss on a security position. This way, setting a stop-loss order for 10% below the stock’s purchase price will limit your loss to 10%. Consider this example to understand the stop loss meaning.

Suppose you purchased Reliance Industries stocks at INR 2,000 per share. After buying the stock, you program a stop-loss order for INR 1,800. If the stock falls below INR 1,800, the broker will sell your shares at the prevailing market price. Fortunately, through the advent of technology, stop-loss orders are automated and do not require human intervention.

This article will help you understand what are stop-loss orders, and what is stop-loss in trading, with its advantages and disadvantages.

Benefits of the Stop-Loss Order

1.    Zero cost

The most significant benefit of a stop-loss order is that there are no extra charges to implement it. You can sell the stock at the regular commission once the share reaches the stop-loss price. A stop-loss order is conceptualised as a free insurance policy for your stock investments.

2.    Easy to implement

You don't have to monitor how a stock performs daily when you set stop-loss orders. This convenience is especially handy when you are on vacation or in a situation that prevents you from monitoring your stocks for an extended period.

3.    Boosts logical decision-making

Stop-loss orders also help insulate your decision-making from emotional influences. People tend to "fall in love" with stocks. For example, they may maintain the false belief that if they give a stock another chance, it will come around. In reality, this delay may only cause losses to mount.

Finally, it's important to realize that stop-loss orders do not guarantee that you will profit in the stock market; you still have to make intelligent investment decisions. If you fail to do so, you will lose just as much money as you would without a stop-loss.

Disadvantages of Stop-Loss Orders

1.    Extremely short-term view 

The primary disadvantage of stop-loss orders is that a short-term fluctuation in a stock's price could activate this trigger. The key is picking a stop-loss percentage that allows a stock to fluctuate day-to-day, while also preventing as much downside risk as possible. Setting a 5% stop-loss order on a stock that has a history of fluctuating 10% or more in a week may not be the best strategy. You'll most likely lose money on the commission generated from executing your stop-loss order.

2.    May not activate in fast-moving markets

Once you reach your stop price, your stop order becomes a market order. The selling price may differ from the stop price. This is especially true in a fast-moving market where stock prices change rapidly. 

3.    Does not apply to all securities

Another restriction with the stop-loss order is that many brokers do not allow you to place a stop order on certain securities like OTC Bulletin Board stocks or penny stocks.

How do stop-limit orders work?

Stop-limit orders are similar to stop-loss orders. However, as their name states, there is a limit on the price at which they will execute. There are then two prices specified in a stop-limit order: the stop price, which will convert the order to a sell order, and the limit price. Instead of the order becoming a market order to sell, the sell order becomes a limit order that will only execute at the decided limit price (or better).

Stop-Loss Orders are also a way to lock in profits

Traditionally, stop-loss orders are known for preventing losses. However, another use of this tool is to lock in profits. Sometimes stop-loss orders are referred to as a "trailing stop." Here, the stop-loss order is set at a percentage level below the current market price (not your buying price). 

The price of the stop-loss adjusts as the stock price fluctuates. However, if a stock goes up, you have an unrealised gain; you do not have the cash in hand until you sell. Using a trailing stop lets profits run for a while, guaranteeing at least some realized capital gain. 

Continuing with our Reliance Industries example, suppose you set a trailing stop order for 10% below the current price, and the stock skyrockets to INR 3,000 within a month. Your trailing-stop order would then lock in at INR 2,700 per share (3,000 - (10% x 3,000) = INR 2,700). This is the worst price you would receive. You won't be in the red even if the stock takes an unexpected dip. 

However, the stop-loss order is still a market order—it simply stays dormant and is activated at the trigger price. Therefore, the price at which your sale trades may be different than the specified trigger price.