How many times did you forget to place the stop loss and were not able to close your trades at the right time? Obvious reasons behind them- emotions or forgetting to keep track of the trade. Retail people usually buy stocks and fall in love with them by holding them unless it becomes profitable. They don’t sell, even if the stock has plundered down 50%, or the fundamentals have worsened. This tendency to stick to loss and not booking it is called the loss-aversion bias. This is also the reason behind big losses in trades and investments.
Sometimes, one may be in their job, doing some work, spending time with friends or family, and may not get the time to look at their trades. This might result in the price going below the point where the exit of the trade was decided. This results in a greater-than-expected loss, pushing the person into this emotional trap. But you need not worry because in this blog post we will be discussing a default order system in the markets to avert such situations. This order type is called stop-loss, and it protects us from these big losses. So, let’s discuss, what is a stop-loss order.
What is a stop-loss order?
Stoploss refers to a strategy used by traders to limit their losses. To do that a stop loss order is placed after the execution of the entry order of the trade. A stop loss order is an automated instruction set by the trader that helps in protecting from the risk of greater-than-expected loss. If the price of a security reaches a certain price level, then the open order of security is automatically closed, with the sell order being executed at the defined price level.
For example – If someone buys shares of Tata Motors at Rs. 400. The trader has a risk capacity of 5%. Then, they will put a stop loss order at Rs. 380 (Rs. 400 – 5%). As soon as the price will hit the stop-loss (Rs. 380), a sell order will be automatically generated, and the shares will be sold. If a stop-loss order would not be put in, then it is possible that the trader may have faced a greater loss if he/she would not be sold after the price moved below Rs. 380.
Importance of stop loss order
When one puts a stop-loss order, the utmost need to track how the stock is performing regularly is reduced to some extent. But that doesn’t imply that you never have to see it. Once the research has been done, the position is open after execution of the entry order, stop-loss order with target has been placed, and a trader’s work is reduced to emotion handling, unless trailing.
Having a stop-loss order placed also saves traders from their emotional biases. Many traders tend to hold on to the stock even after it has been continuously falling. Stop-loss automatically sells the stock at the price set by the trader. Therefore, some of traders don’t place stop-loss orders and face severe losses. Loss in markets can never be prevented but can be mitigated. Stop-loss orders help in mitigating losses and should always be placed.
Types of Stoploss order
There are two types of stop-loss orders –
- Stop-loss Market order (SL-M) – In a stop-loss market order, the sell order is executed at the current market price as soon as the share price hits the trigger price.
For example – Suppose you buy a share at Rs. 400. You put a stop-loss market order at Rs. 380. As soon as the share price falls below Rs. 380, the order is triggered, and the shares will be sold at whatever will be the market price of the company at that time.
One of the biggest disadvantages of this type of stop-loss order is that if the market price drastically falls to say, Rs. 370 then the shares will be sold at the market price
of Rs. 370. This will increase losses to an unlimited extent. The only benefit is that, at least, the order will be closed.
- Stop-loss Limit order (SL) – In a stop-loss limit order, the prices for the limit price as well as the trigger price need to be inputted. Once the trigger price is reached or crossed, the order is triggered, and a sell order at a limit price gets introduced in the market. Let’s understand this by an example:
For example – Suppose you buy a share at Rs. 400. You put the SL trigger price as Rs. 380 and the limit price as Rs. 381 (The limit price for a sell SL order is greater than the trigger price). As soon as the share price crosses the trigger price is reached, that is Rs. 380, a sell order of Rs 381 gets placed into the market. The order will be executed when the price reaches Rs 381, from 380. Thus, it is better to place the limit order as close as possible to the trigger price.
One of the biggest disadvantages of a stop-loss limit order is that if the order is not executed within the price range and the trade remains open, there is a probability that the price may not come back to that price range and experience a drastic fall.
To put it plainly, if after the trigger price, the limit price set by the trader is not met, the open position will not get closed. Let’s understand this by an example.
Taking the above case assuming there were no buyers available between Rs. 380 and Rs. 381, and the price fell to Rs. 375, never reaching 381 the trade would still be open, and you would experience a bigger loss. However, this type of stop-loss order is used by traders when they do not want to sell the share below a certain price and want to wait for the share price to come back to the previous range.
Now comes the question, which one is better – a Stop-loss limit order or a Stop-loss market order? There is no definite answer to this. The answer depends on a person’s style of trading, the liquidity of the stock, which is being traded, the range of fluctuation in the stock, etc. However, even if you do not monitor your trades regularly and are a passive trader, you should use a stop-loss limit order, as you never know what might market price be after the trigger is hit. Many have suffered huge losses by setting up SL Market orders in Options.