Trust me. It’s easy to overlook certain essential variables when deciding whether or not to buy a specific stock. One of those considerations is the stop-loss order. A stop-loss order, when used correctly, can make a huge impact.
What is a Stop-loss order?
A stop-loss order is a request made to a broker to buy or sell a specific stock at a specific price once it hits that price. A stop-loss order is an important strategy to keep an investor’s loss to a minimum. Setting a stop-loss order 5% below the price at which you bought the stock will restrict your loss to 5%. Let’s say, for example, Ram bought Tata Consultancy Services (TCS) shares at INR 3000 per share. Ram places an INR 2850 stop-loss order immediately after buying the stock. In this case, Ram’s TCS share will be sold at the current market price if the stock falls below INR 2850.
Stop-loss order: Protect against losses and lock in earning
Stop-loss orders have long been looked at as a tool to protect against losses. However, this method can also be used to lock in earnings. Stop-loss orders are sometimes referred to as “trailing stops” in this situation. The stop-loss order is set at a percentage below the current market price in this case (not the price at which you bought it). As the stock price swings, the stop-loss price adjusts. It’s vital to remember that if a stock rises in value, you’ll have an unrealized gain because you won’t have the money until you sell. Using a trailing stop allows you to let profits run while also ensuring that at least some capital gain is realized.
Let’s say you place a trailing stop order at 10% below the current price, and the stock rises to INR 100 in a month. Your trailing-stop order would therefore be triggered at INR 90 per share (INR 100 – 10% x INR 100) (INR 90). Because this is the lowest price you can get, even if the stock drops unexpectedly, you won’t lose money. Keep in mind that the stop-loss order is still a market order; it merely remains dormant until the trigger price is reached. As a result, the price at which your sale trades may change somewhat from the trigger price.
Key Benefits of Stop-Loss Order
The most important advantage of a stop-loss order is that it is free to use. When the stop-loss price is reached and the stock needs to be sold, your standard commission is charged. You can consider your stop-loss strategy as a free insurance policy.
A stop-loss order also has the advantage of removing emotional factors from the decision-making process. Stocks tend to make people “fall in love.” They tend to the wrong assumption that if they give a stock another chance, it will turn around. In reality, this delay might only increase the loss.
You should be able to easily identify why you own a stock, no matter what sort of investor you are. The requirements of a value investor will differ from those of a growth investor, which will differ from those of an active trader. No matter what approach you use, these strategies will only be effective if you stick to them. If you’re a die-hard buy-and-hold investor, a stop-loss order makes no sense.
If you want to be a successful investor, you must have total faith in your plan. Stop-loss orders have the advantage of keeping you on track and preventing your judgment from being affected by emotion.
Finally, keep in mind that stop-loss orders do not guarantee that you will profit in the stock market; you still make need to execute sound investment decisions.
Stop-Loss Orders and its downside
One advantage of a stop-loss order is that it eliminates the need to monitor a stock’s performance daily. This feature comes in helpful when you’re on vacation or in a situation where you can’t keep an eye on your stocks for an extended period.
The biggest downside is that a short-term price change in stock can cause the stop price to be activated. The goal is to choose a stop-loss percentage that permits a stock’s price to fluctuate day to day while minimizing negative risk. Setting a 5% stop-loss order on a stock with a history of weekly price fluctuations of 10% or more may not be the ideal strategy.
There are no hard-and-fast guidelines for where you should position your stops; it all relies on your investing approach. A 5 percent level might be used by an active trader, while a 15% level might be used by a long-term investor.
Another thing to keep in mind is that your stop order will become a market order if you reach your stop price. As a result, the price at which you sell may differ significantly from the stop price. This is especially true in a fast-paced market where stock prices can fluctuate dramatically.
Stop-limit orders carry additional dangers. These orders can ensure a price limit, but they do not guarantee that the deal will be executed. If the stop order is triggered but the limit order is not filled before the market price bursts through the limit price, this can be harmful to investors in a quick market. If a company receives terrible news and the limit price is only $1 or $2 lower than the stop-loss price, the investor must keep the stock for an indefinite period before the share price recovers again.
Although a stop-loss order is a simple tool, many stock traders and investors fail to use it to its full potential. Almost all investing approaches can benefit from this strategy, whether it’s to avert excessive losses or to lock in profits.
Consider a stop-loss as an insurance policy: you hope you’ll never need it, but it’s nice to know you’re covered in case you do.