Why a Stop-Loss Order is Critical in Trading Shares
The same way it is necessary to put a seat belt while driving, it is also important to set a stop-loss order in the stock market. A stop-loss order acts as a safety measure to limit potential losses and protect your investments. Without this crucial tool, traders risk substantial financial injury due to unexpected market movements.
What is a Stop-Loss Order?
The critical factor for a successful trade is to manage the risk, and this is where a stop-loss order comes into play. A stop-loss order helps investors or traders to control the uncertainty in the trade by defining the maximum acceptable loss.
A stop-loss order is a predetermined price level at which a stock is sold to minimize potential losses. Traders can place these orders in their trading platforms and modify them as needed. When the stock price reaches the specified stop price, a market order is automatically triggered, selling the stock at the best available price in the market.
Types of Stop-Loss Orders
There are several types of stop-loss orders that traders can use depending on their trading strategy and risk tolerance.
Time-based Stop-Loss
When a breakout occurs, and follow-up buying is not evident within 10-15 minutes, a time-based stop-loss can be used to close the position if necessary. For example, if the market breaks a critical support level, a stop-loss order can be placed to protect profits or limit losses.
Technical-based Stop-Loss
A technical-based stop-loss order uses technical parameters such as support and resistance levels, candlestick patterns, or breakout trends to determine the stop price.
Percentage-based Stop-Loss
Diligent traders set a maximum percentage of their capital as the stop-loss per trade. This ensures that they do not risk too much on a single trade and maintains a disciplined approach to trading.
Absolute Stop-Loss
An absolute stop-loss order is expressed in total or actual money terms. For example, setting a maximum of Rs 5000 as the stop-loss for a trade. This helps to limit the potential losses to a certain amount of money rather than a percentage of the capital.
Trailing Stop-Loss Order
A trailing stop-loss order is different from other types as it adjusts the stop price automatically as the market moves in the trader's favor. Trailing stop-loss enables the trader to lock in profits and protect against losses if the market reverses.
For example, Ms. Akshatha bought 100 shares of SBI at Rs 300, hoping it would go to Rs 310. She initially placed her stop-loss at Rs 297. When the price moved to Rs 305, she adjusted her stop-loss to Rs 303, locking in a profit of Rs 3 per share. If the price continued to rise, she could move the stop-loss further, maximizing potential profits. However, if the price reversed and moved down, the trailing stop-loss would trigger, and the position would be closed with a Rs 6 per share profit, ensuring at least some minimum profit while still allowing for the potential for higher gains.
Major Drawbacks of Stop-Loss Orders
While stop-loss orders are essential, they are not a guarantee against loss. They can fail to protect against sharp declines or gapping down scenarios, where the market falls significantly and the stock price can drop below the stop-loss level before the order is executed.
Improperly setting a stop-loss, especially one that is too tight relative to the stock's volatility, can result in frequent triggering and subsequent losses. Similarly, a trailing stop-loss can be too loose or too tight, depending on the stock's volatility, and may fail to effectively protect profits or lock in gains.
Bottom Line
While stop-loss orders are not a cure-all for financial injury in the stock market, they are a valuable tool for managing risk and protecting investments. A disciplined approach to using stop-loss orders can help traders achieve their desired level of risk-reward and maintain a balanced trading strategy.
Remember, a stop-loss order is a money management tool that sets limits on potential losses in a trade. By using stop-loss orders, traders can control the risk associated with their trades and be more disciplined.