6.1 Introduction
To be a successful investor you must decide on your investment objectives, and then get a strategy that will work for you, and most importantly, establish rules for limiting your losses that you will adhere to. Don't leave it to chance or you'll be left with chump change. The importance of a Stop Loss can't be stressed enough. It is very simple. When you purchase, know exactly what your maximum potential loss will be.
What is a stop-loss order?
A stop-loss order is a risk management tool investor, and traders use in the financial markets. It is a command given to a broker or trading platform to sell a security automatically if its price reaches a predetermined level, known as the stop price. The objective of a stop-loss order is to limit potential losses by exiting a position before the price falls further. It acts as a safety net, ensuring you don't suffer excessive losses if the market moves against your trade.
Understanding Stop-Loss Orders
Stop-loss orders define a specific price level at which an investor is willing to accept a loss. When the market price falls below or reaches the stop price, the stop-loss order becomes a market order, triggering the sale of the security at the prevailing market price. By setting a stop-loss order, you can automate the process of cutting your losses and minimize the emotional decision-making that can lead to poor trading outcomes.
Example of Stop Loss
Let's look at an example of a good Stop Loss. We'll use the axis bank chart and for the long-term investor who was using the 200 DMA as a signal to buy and sell. As I mentioned earlier, some investors use the crossing of the 200 DMA as a buy and sell signal. In this case, a sale would have been made when the axis fell below the 200 DMA at Rs.535. Then a purchase would be made at Rs.475 per share when Axis bank crossed back over the 200 DMA to the up-side.
The key to every trade or investment is to limit your potential loss. In this case, the purchase was made at 475 and even an 8% loss would have sold you out at Rs.439. Therefore, as soon as you made the purchase at 475, you should have entered a Stop Loss to sell
Types of Stop-Loss Orders
Several types of stop-loss orders cater to different trading strategies and risk preferences:
- Market Stop-Loss Order: This is the most common type of stop-loss order. It instructs the broker to sell the security at the prevailing market price once the stop price is reached.
- Limit Stop-Loss Order: With this type of order, you can specify a minimum price at which you are willing to sell the security. If the market price hits the stop price, the order converts into a limit order and will be executed only if the cost can be achieved or improved.
- Trailing Stop-Loss Order: A trailing stop-loss order is a dynamic order that adjusts the stop price as the market price moves in favour. It allows you to capture profits while still protecting against potential losses. If the market price reverses by a specified percentage or amount, the trailing stop price will get triggered, and the order will get executed.
Purposes of Stop-Loss Orders
Stop-loss orders serve various purposes in trading and investment strategies:
- Risk Management: The primary purpose of a stop-loss order is to manage risk. It helps limit potential losses and protects your capital if the market moves against your position.
- Emotion Control: By predefining your exit point with a stop-loss order, you can avoid making impulsive decisions based on emotions or short-term market fluctuations. This promotes discipline and reduces the impact of emotional biases on your trading decisions.
- Profit Protection: Stop-loss orders can also protect profits by adjusting the stop price as the market price moves in your favour. This way, you can lock in gains and ensure that a profitable trade doesn't turn into a losing one.
Advantages and Disadvantages of Stop-Loss Order
Stop-loss orders offer several advantages and disadvantages that traders should consider:
Advantages:
- Risk Control: Stop-loss orders help manage risk by limiting potential losses and protecting capital.
- Automation: Once a stop-loss order is set, it becomes automated, removing the need to monitor positions constantly.
- Discipline: Stop-loss orders promote disciplined trading by enforcing predefined exit points and reducing emotional decision-making.
Disadvantages:
- Market Volatility: In highly volatile markets, the security price can gap down, bypassing the stop price and resulting in a more considerable loss than anticipated.
- Stop-Hunting: Some traders believe that market participants may deliberately push the price to trigger stop-loss orders, leading to unnecessary selling pressure.
- Whipsawing: Whipsawing occurs when the market price briefly hits the stop price, triggering the stop-loss order, then reversing in the opposite direction. This can result in frequent stop-outs and potentially missed profitable opportunities.
Stop-Loss Order Vs. Market Order
Stop-loss orders and market orders are two different types of orders used in trading:
- Stop-Loss Order: A stop-loss order is triggered when the market price falls below or reaches the stop price. It becomes a market order, and the security is sold at the prevailing market price.
- Market Order: It is a command to sell or buy a security at the best available price in the market. It doesn't have a predetermined price level and is executed immediately.
The critical distinction is that a stop-loss order is contingent upon the price reaching a specific level, while a market order is executed at the current market price.
Stop-Loss Order and Limit Order
Stop-loss orders and limit orders are both conditional orders used in trading:
- Stop-Loss Order: A stop-loss order is triggered when the market price falls below or reaches the stop price. It converts into a market order and gets executed at the prevailing market price.
- Limit Order: It is a command to sell or buy a security at a specific price or better. It limits the maximum price to buy or the minimum price to sell.
The critical difference is that a stop-loss order becomes a market order, while a limit order remains a limit order until the specified price or better is reached.
Importance of Stop-Loss Order
The importance of a stop-loss order in trading cannot be overstated. It provides several key benefits:
- Risk Mitigation: Stop-loss orders help protect your capital and preserve your investment portfolio by limiting potential losses.
- Disciplined Trading: Stop-loss orders enforce disciplined trading, preventing emotional decision-making and reducing the impact of biases.
- Peace of Mind: Knowing that you have a safety net allows you to trade confidently and focus on long-term strategies.
Limitations
While stop-loss orders are valuable risk management tools, they also have certain limitations that traders should be aware of:
- Market Volatility: During extreme volatility or news-driven events, the market can move rapidly, causing gaps that bypass stop prices.
- Timing Risk: Stop-loss orders do not guarantee execution at the exact stop price. They may be executed at a different price if there is a market gap or lack of liquidity.
- False Signals: Stop-loss orders can be triggered by short-term market fluctuations, resulting in premature exits and missed opportunities.
your shares if the price dropped below, let's say 439. That way the maximum amount you would lose is Rs.38 per share. It wouldn't matter then if Axis bank crossing over to the positive side of the 200 DMA happened to be a false rally in the market and the price turned and fell back to its previous low of Rs.374, or even lower. You are protected and will not lose more than your set amount.
Don't be greedy or scared and enter a Stop Loss for only a few cents below your purchase. Every stock must have some breathing room and you don't want to get sold out senselessly. The 6% to 8% rule has been around for years. There is a reason this amount is used to Stop Losses. Meaning, normally if the price drops more than 6% to 8% then there is a valid reason for that much decline. And chances may be pretty good that it will drop further.
6.2 Trailing Stop Loss
In continuing our previous example, the wise investor re-purchased shares of axis after the bear market when it crossed the 200 DMA, and placed a trailing stop loss. A trailing stop loss is set to automatically move higher as the stock advances. It can be set to trail at any amount you choose, for instance, maybe Rs.30 below the current price. Thus, every time the stock moves higher, the stop-loss moves to stay Rs.30 below the price.
A trailing stop loss is a very good way to capture more profit and protect your investment money at all times. Using a trailing stop loss can capture more profit for you when used properly. By automatically moving higher as the stock advances it preserves most of your gain. Yes, you will occasionally be sold out and then have to wait for another entry point. But in the event there had been a Trailing Stop Loss in place as Axis Bank was advancing, then instead of selling out when Axis Bank fell under the 200 DMA, you would have been sold out at a higher price.
For instance, if you felt there was a correction in the market due to happen in the near future since Axis Bank was significantly higher than the moving average, you might have tightened up your trailing stop loss by setting it at Rs25 below the current price, then you would have benefited by capturing more of the gains and been out of the trade quicker.
As you can also see, there are many zigs and zags in the price as it advanced during 2016 and 2018. Yes, a stock can trade significantly above the 200 DMA for extended periods of time, but will eventually return to the moving average. In this case, a trailing stop loss would have worked well keeping it low enough to allow 'breathing room' yet higher than the 200 DMA to preserve as much gain as possible.
6.3 Two Important Things to Remember About Stop Loss
There are ONLY TWO things to remember about a Stop Loss.
- USE IT! Without a Stop Loss, you are simply flirting with disaster, and sooner, rather than later, you will find it, or it will find you. When you enter into an investment, place your Stop Loss immediately. Always.
- Don't Get Creative- A very good habit to form is this. If you place your trade online, then never get up from your computer after you enter your trade without placing your Stop Loss. The Stop Loss IS part of the trade. It is that important. Regardless, whether you are buying or selling short, a Stop Loss will not eliminate the risk. Risk is always there regardless. But common sense certainly tells us that a Stop Loss will 'Limit' the risk. That is what is important. Always place the odds in your favor.
