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Stop-loss order: An effective way to limit the loss by stock's price fall

A visitor stands in front of private stock trading boards at a private stock market gallery in Kuala Lumpur, Malaysia, Friday, Dec. 7, 2018. Asian shares were mostly higher Friday after gains on Wall Street but investors continued to watch for news about U.S.-China trade friction. (AP Photo/Yam G-Jun)Premium
A visitor stands in front of private stock trading boards at a private stock market gallery in Kuala Lumpur, Malaysia, Friday, Dec. 7, 2018. Asian shares were mostly higher Friday after gains on Wall Street but investors continued to watch for news about U.S.-China trade friction. (AP Photo/Yam G-Jun)

  • To prevent incurring huge losses during rapid fall in stock prices, investors tend to use a stop-loss option which executes a sale in case stock slides below a threshold. Let us understand what does it mean

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Stop-loss is a tool to prevent unlimited loss wherein security is sold if its price slips below a pre-decided level.

To buy or sell a security when its price falls below a certain level, you would issue a stop-loss order with your broker. When it comes to stop-loss orders, they are used to limit an investor's loss on a secure foothold. These orders are distinct from stop-limit orders, which are used to limit gains.

As soon as a stock goes below the stop price, then it becomes a real order, and it's executed at the next open market rate. As an illustration, a trader may purchase a stock and set a stop-loss order 10% below the purchase price.

In case of the stock drops, the buy order will be activated and the stock will be sold as a purchase order as well.

While most investors think of order as protecting a long-term investment, it can also safeguard a short-term investment, in which case the protection is purchased if the price rises above a certain level.

Understanding stop-loss order

Traders and investors may place a higher emphasis on using an order to protect their earnings. Since it becomes an order, the risk of an order not being performed is removed. When the value goes below the stop price, a stop-limit order is triggered; however, the order may not be executed due to the value of the limit section of the order.

If a stock unexpectedly drops below the stop price, using stop-loss can be risky. The order would go into effect and the stock would be sold at the next available price, regardless of whether it was trading far below your stop-loss threshold.

An order to sell something refers to the customer asking the broker to do so if the price of the security falls below a certain threshold. The stop price is just above this amount in a highly bullish order.

Example of stop-loss order

A trader purchases 100 shares of XYZ for 100 and places a stop-loss order at 90. Over the next three weeks, the stock price drops to below 90. The trader's order is executed, and the position is sold for 89.95 to complete the transaction.

A trader buys 500 shares of ABC Corp. for 100 and places a new stop-loss order at 90. As a result of the company's dismal financial results, the stock price has dropped by more than half. Because of this, the trade gets executed at a price of 49.50 when the market reopens, triggering the stop-loss order.

Make sure you use stop-loss order

When weighing the pros and drawbacks of buying a stock, it's easy to overlook some key factors. One of such aspects could be the order in which things are done. A purchase order, when used properly, can have a huge impact. This tool is accessible to practically everyone.

Advantages of the stop-loss order

An order has the major benefit of being completely free to implement. You will only be charged your standard commission if the stop-loss price has been reached and the stock has to be sold. One way to look at a purchase order is as a form of unrestricted insurance.

A purchase order also has the benefit of removing emotional factors from the decision-making process. Stocks tend to make people "smitten." An illustration of this would be the myth that if people give an underperforming stock one more opportunity, it would turn around. In fact, if this delay continues, the damage could get worse.

Any investor should be able to quickly and easily identify why they own a particular asset. The standards of a value investor differ from those of a growth investor, which can differ from those of an eager trader. Whatever the strategy, it will only work if you stick to it. Stop-loss orders are nearly useless if you're a fervent buyer and holder of stocks.

At the end of the day, if you want to be a successful investor, you need to have faith in your plan. This requires following through on your plans. Stop-loss orders have the advantage of allowing you to stay on course while also preventing your judgement from being affected by emotion.

Finally, keep in mind that stop-loss orders do not guarantee a profit in the stock market; you still have to make wise investment choices. If you don't, you'll suffer losses equal to or greater than those you'd suffer in the absence of a stop-loss, albeit at a slower rate.

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

Stop-loss orders have long been considered the simplest approach to prevent losses. However, this technology can also be used to secure earnings. Stop-loss orders may be used as a "trailing stop" in this situation. The stop-loss order is set at a percentage level below the current market value (not the worth at which you acquire it). Because the stock price changes, so does the stop-loss amount.

It's critical to remember that if a stock price rises, you've accrued an unrealised profit; you won't have the upper hand until you sell. Using a trailing stop gives you the freedom to let profits run while still assuring at least some monetary advantage.

Let's go with the XYZ example from earlier and say you place a trailing order for 10% below this price and the stock soars to Rs.30 within a month that your trailing order is triggered. Your trailing-stop order would then be locked in at Rs.27 per share (Rs.30 - (10 percent x Rs.30) = Rs.27).

Because this is the lowest price you could get, even if the stock takes a sudden tumble, you won't be losing money. It's important to keep in mind that the purchase order is still a market order; it's just dormant until the trigger price is met. As a result, the value at which your sale actually happens may fluctuate significantly from the trigger price desired.

Disadvantages of stop-loss order

If you use a stop-loss order, you won't have to check the stock's performance on a daily basis. This benefit is especially useful if you're going on vacation or otherwise unable to keep an eye on your portfolio for an extended length of time.

However, a short-term price change in stock could trigger the stop price. The idea is to choose a stop-loss percentage that permits a stock's price to fluctuate on a daily basis while also preventing as much downside risk as feasible. The ideal technique may not be to set a 5-percent stop-loss order on a stock with a history of fluctuation of at least 10% in a week. Stop-loss orders are designed to prevent you from gaining more money than you lose when they are executed.

Stop-loss levels aren't set in stone; instead, they're based on your personal investing strategy. It is possible that active traders will set their stops at 5 per cent, whilst long-term investors will set their stops at 15 per cent or higher.

Another thing to bear in mind is that your stop order will become a market order once you've reached your stop price. Selling at a considerably higher or lower price than the stop price is possible. When the stock market moves quickly, this point becomes much more important. Another limitation with the stop-loss order is that many brokers do not enable you to put a stop order on certain assets like OTC Bulletin Board stocks or penny stocks.

Stop-limit orders carry additional dangers. These orders can guarantee a price limit, but the trade may not be carried out by the market participant.

Even though a stop-loss order is a straightforward tool, many investors fail to make use of it. Almost all investment styles can benefit from using this instrument, whether to avoid large losses or to lock in profits. Stop-loss orders are like insurance policies - you hope you'll never need it, but it's comforting to know you're covered.

 

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