Discover the importance of a Stop Loss strategy in protecting your investment portfolio
Stop loss is a trading strategy whereby a trader sets an order—in advance—to sell the stocks once they reach a particular price point, be it to limit the losses or gains. Also referred to as stop order or stop-market order, stop loss applies to both short-term as well as long-term trading.
It comes in handy when a trader does not want to monitor stock prices on a day-to-day basis, rather an automatic order gets triggered once the stock coincides with the set limit.
If Mr. X wants to place a bid to acquire the stocks of a company at a certain price, s/he applies the stop order to purchase the particular stock. Once the stock reaches such a price point, the order will be complete.
Likewise, if Mr. X owns the stocks of a particular company and wants to exit, s/he sets the stop order at a price point desired. In accordance, the order gets triggered once the price matches the set price point and executes.
There exist no hard-and-fast rules to placing your stop loss order. An active trader might prefer 5%, whereas a long-term investor might opt for 15% or more.
Example
Suppose Mr. X bought the stocks of a company ABC at $200 per stock. To limit the potential loss, he set the stop order at 10% below the purchase price—which equals $20 per stock.
Now, ABC’s stock starts declining and reaches the price of $180. As a result, it triggers Mr. X’s stop order proceeding ABC’s stock to sell at the prevailing market price of $180.
Pros of a stop-loss order
It costs nothing to implement a stop loss order as the brokerage won’t charge you for setting the stop orders. In addition, you do not need to monitor the daily price fluctuation of a stock you bought. It comes in handy when you are in a condition that is preventing you from watching the stocks for some time. For instance, a vacation or a trip. It makes your decision-making effective by eradicating the emotional triggers. When people fall prey to emotional affection for a particular stock, giving it another chance in the hope that the stock would rebound, could bulk up the losses to a higher degree.
As you would be acting as a trader—not the investor—the buy-and-hold strategy is not the one you would be opting for. So, it is a compulsion that you include a stop-loss order as a strategy. Not only do stop-loss orders help traders avoid loss, but also aid them in booking profits, referred to as trailing stop loss briefed below as stop-loss order adjusts under price fluctuation.
Cons of a stop loss order
Volatility depicting the stock market might hit the stop loss you set too frequently eroding your capital considering the brokerage fee and reduction in the capital in case of a downward market trend.
The short-term price fluctuations of stock could activate the stop you set and trigger an unnecessary sale.
A stop loss order would not allow a trader to place a stop order on penny stocks—a stock of a small company that trades at a very low price.
Significance of a stop loss order
Stop loss helps prevent large and uncontrollable losses in volatile trades, especially in the bearish run of the market. If not applied, it can wipe out a huge chunk of the trading profit or start diminishing the capital gradually. Hence, for every trade you execute, stop loss is inherent.
In an industry—the stock market—where discipline is utmost to succeed, one can result in poor practice due to an emotional trigger and ultimately losses. In such a scenario, stop loss helps eradicate such losses when applied by a trader.
Stop loss helps prevent loss aversion as a trader automatically exits rather than holding or losing onto the trades.
What if the stock rebounds once you exit?
We are bound to make mistakes and so, not every time trade could be executed with perfection. Sometimes, the stock might rebound once you exit. If such a case occurs, we must be ready with our next move rather than blaming our trading decision.
Suppose you exit the trade once you hit your stop order of 15% and the stock rebounds and surges higher. It might be frustrating, for the very first time, to see such a turnaround. To keep things simple, you should not think that you made the wrong decision or such. You have made such a decision to protect your portfolio. Sometimes, taking a small loss can protect you from suffering a devastating loss. What if the stock just surged and once again followed its bearish trend? Stocks do not go vertically downwards, even in a bearish market you should keep in concern that stocks move ups and downs in the bearish trend too. The difference is that red candles outweigh the green candles.
Nevertheless, you always have the option to buy back the shares once they show positive strength in the market, and ultimately, the profit you would garner diminishes and overcome the loss you faced earlier. Think of the loss that you previously faced as an insurance premium merely to eliminate higher losses in the market.
It is also to be noted that the stocks generally do not fall below 15% or more if the general market is acting well. However, there exist exceptions such as economic turmoil in the nation. When the stock triggers a 15% stop loss, it indicates to you that something isn’t right. Therefore, the decision you took could turn out to be fruitful. In rare cases, the stock might rebound. However, it is not guaranteed that it won’t continue the bearish trend and dip down further which a trader must be aware of.
Buy stop loss and Sell stop loss
If a trader is opting for a short position—a trader anticipates that the stock would decline in the short term, be it a few days apart or a week—s/he would place a buy-stop loss order with the expectation of stock dipping down.
On the other hand, if a trader is opting for a long position—a trader owns the stock in the expectation of stock rising in value in coming days—s/he would place a sell-stop order. It is therefore the sell stop loss order would be set below the current market price ultimately leveraging the trader when the stock price surges.
Trailing stop loss
Unlike the regular stop loss, trailing stop loss would follow or trail the price of a stock as it fluctuates. Hence, it can be considered as the percentage set or a particular price point away from the current stock price.
When the price of a stock surges, the trailing stop drags along with it. When the price stops surging, the new stop loss now adjusts at the level it is dragged up to. Hence, on the one hand, it safeguards investors’ downside; on the other hand, it locks the profit when the price reaches new highs.
Trailing stop loss is considered effective as it allows a trade to stay open and profit as long as the trade executes in the trader’s favor, aiding him/her to cope psychologically alongside the volatility depicted in the stock market.
Suppose, Mr. X purchased a particular stock at $100 per stock and set a stop-loss order at 10% of the market value. As a result, the sell order gets automatically executed once it hits the price of $90.
Suppose, the stock price rises to $130. As the trailing stop loss order stands at 10% of the current market price, now the trailing order is at $117 per stock. After a while, if the stock starts falling once reaching $130, the new stop-loss order will be now executed at $117. Ultimately, the capital gain would be $130-$117 = $13 per stock. However, it is to be noted that the trigger price could be lower than the set price depending on the timing of stock price movements.
Final Takeaway
Traders with no strong trading plans are bound to incur significant losses. Risk management must be a core tactic to execute your trading strategy for which a stop-loss strategy is a must. Market entry and exit rules with top concern over risk and reward ratio provide you with an effective stop order point. However, a trader must admit that the incurrence of loss during trading is normal, and not every trade execution will turn out to be successful. Keeping such a fact in concern, traders thereby must not overlook stop loss strategy by any means. Taking into consideration the stop order, a trader can go a long way limiting the losses on one hand and garnering profit over the haul on the other hand. You must be willing to take responsibility for the losses incurred. If not, you won’t analyze why you failed the particular trade and what mistakes you should not be making on the very next trade that you execute. In accordance, one must adjust the trading parameters with the aid of various technical indicators from the next time onwards.
