What is Stop Loss in the share market?

5paisa Research Team

Last Updated: 07 Aug, 2024 10:30 AM IST

What Is Stop Loss in Stock Market?
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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.


 

More About Stock / Share Market

Disclaimer: Investment in securities market are subject to market risks, read all the related documents carefully before investing. For detailed disclaimer please Click here.

Frequently Asked Questions

Yes, setting a stop-loss order will sell your stock at the specified price. A stop-loss order is an automation tool that sells your stock as soon as the price falls below the set price.

Traders customarily place stop-loss orders when they initiate trades. Initially, stop-loss orders are used to put a limit on potential losses from the trade.
 

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