There are various types of trading orders that a trader can use to instruct the broker to buy or sell a security on his behalf. These trading orders differ in the mode of execution and may be conditional or unconditional. One of the trading order types is the Stop Loss Order.
In this quick review, let’s try to understand its meaning, buy/sell order strategy, benefits along with a few examples.
But as usual, let’s start with a few basics!
Stop Loss Meaning
Stop loss order remains dormant until a particular price is reached and becomes active as soon as it hits the target price.
This target price is decided and set by the trader himself. The purpose of stop loss is to limit the losses and protect the profits.
The basic concept behind stop loss is to stop the trade immediately as the market starts moving against what is expected by the trader so that he does not bear too much loss and is able to keep the gains earned by him.
For example, if a trader holds a particular share at Rs 150 and he puts the stop loss at Rs 130, then the security will automatically be triggered to be sold at Rs 130 so that the trader does not bear much loss (detailed example later).
Stop loss order can be both buy stop loss and sell stop loss:
Buy Stop Loss Order
A buy stop-loss order is an instruction to the broker (by call or by the trading platform) to buy the security at the stop price. It is placed above the current market price and it makes sure that the trader does not end up buying the security at a very high price.
It is mostly used when the trader wishes to exit a declining market close to the bottom after a turnaround and to exit a short trade.
This is also useful for buying the breakouts above the resistance level when the trader is not sure of the exact price he will end up buying the security at.
Sell Stop Loss Order
A sell stop loss order is an instruction to the broker to sell the security at the best available price after the price drops down below the stop price.
It is placed below the current market price so that the trader is able to sell the security at such a price that he does not bear too much loss and still retains his profit.
This is used to exit a long trade or to sell on breakouts below the support level when the trader is not sure of the exact price he will end up selling the security at.
As soon as the target price is reached, the stop loss order gets converted into a market order and gets executed immediately.
In this case, if the market is highly volatile, the buy or sell price of the market order may or may not be close to the stop price, as due to volatility the price of the security may get changed in the period between triggering of stop loss and execution of the trade. The stop-loss order does get filled definitely.
A stop order may also get converted into a limit order if the limit price was mentioned.
In this case, when the stop loss price is reached, the trade does not get executed immediately, but when the specified limit price is reached or better.
Therefore, a stop limit order may or may not get filled, or get partially or fully filled depending on whether the limit price was reached by the market or not.
This is to be kept in mind that the stop loss orders may not always be accepted. The market makers and analysts at the exchange have the rights to refuse to accept the stop-loss orders under certain market conditions.
Also, stop orders are not applicable to all securities.
In all cases, it is advisable to use the stop loss to protect oneself from unprecedented losses and to retain the profits earned.
Stop Loss Strategy
When you use stop loss in your trades, there are multiple strategies that can be put in place to make the ideal use of this concept.
But do you do that?
Or you stay confused on the “exact” price point you must be using as the stop loss.
Honestly, you are not alone! There are 1000s of traders out there who get vulnerable when it comes to this point in their trade placements.
Some of the strategies that you can follow are:
One Size NEVER fits all
Well, to understand this strategy, we will take a quick example.
Let’s say you are trading through a volatile stock, for instance – ABC Corp which has been in the news for some negative media reports. The stock generally trades in the range of 40 to 45 PIPs.
Therefore, the average movement in the stock price stays around 5 PIPs.
Thus, it would make sense to keep a stop loss in the range of 35-38 if you are invested in the stock.
At the same time, let’s say you are invested in a commodity IRON (made-up), which is priced at 500. The average daily movement of this commodity is in the range of 30-40 PIPs.
Now, you cannot use the same rule of 5 PIPs in this case as the movement level and size is way different here.
Therefore, never fixate yourself in terms of the number of PIP units that works for you as the stop-loss level for every product you are invested in.
A lot of beginner level traders commit this mistake and end up either exiting the trade very quickly or not exiting at all while incurring high losses.
Larger the Stop Loss, Smaller Your Position
Well, this one is relatively easier to understand.
The stop-loss is the price point which is only specific units away from putting you out of the trade. If you put a larger stop-loss, you are coming closer to the current market price and thus, leaving much lesser room for you to stay in the trade.
Yes, it makes the whole trade less risky but at the same time, leaving you really close to the market price. If the market is marginally volatile, the first thing that will happen is you exiting the trade.
While what could have happened in this volatile market is that the stock may have reversed the trend and hit your target price, bringing you the profit you were actually looking for.
Relatively higher risk brings higher chances of profits too!
Rest, it also depends on the risk appetite you may have.
Therefore, it is highly recommended that you perf0rm specific analysis every time you are deciding your stop loss and your corresponding target price for the trade.
Remember, you are in for a profit here and staying invested in the stock is what ideally you be looking at!
Use Volatility Stops
As the name suggests, this strategy has a lot to do with market volatility. In fact, you decide the stop loss based on the current market volatility.
For instance, if the market volatility is high, you can go a bit wild (or rather wide) in placing your stop loss and target price points for larger market swings.
At the same time, if the volatility is low, it makes sense to keep the range limited (as discussed in the above strategy as well).
This is really important to understand that while you are placing a wider stop loss, you should ideally be putting in a wider target price as well so that you are balanced in terms of the risk-reward ratio.
Else, you may be looking at a trade that has a higher risk appetite but limited profit potential.
Stop Loss Order Example
Although, we have taken an example above but to make sure that you understand the concept thoroughly, let’s take another example.
Let’s say that you own 1000 shares of ABC Incorp. each priced at INR 200.
The market is volatile and as per your analysis, the market may move in any direction.
Thus, you have decided to exit off 500 of those shares.
So what do you do?
You place a target price, let’s say in the range of INR 250 while putting up a stop loss at INR 180. In other words, you are relatively bullish but are trying to limit your losses in case your analysis is incorrect.
With these price points, you are looking at loss of 10% in case the market goes south and a potential profit of 40% if your analysis is correct.
However, the choice of these two price points must be made based on the strategies discussed in the above section.
So far we have discussed that how stop loss can help you in minimizing the losses. But the question that most of the traders is concerned about is how to calculate the stop loss.
Although defining the stop loss is about your risk and the loss you can incur from the particular trade, but in case you are confused as if where the stop loss should be set then there are three methods you can consider.
Support and Resistance Level
Moving Average Method
The percentage method is usually how much percent below or high the stop loss must be set to buy or sell a particular share. Now again this is set and calculated according to the volatility and the loss you can bear.
For example, the buying price of the share is ₹2000 and you are looking ahead to profit but at the same time can face the loss of 10% then here you can set the stop loss in the range of 8% to 10%, and thus the value would be ₹1800-₹1840.