What is Stop-Loss Order? :: Pros and Cons

What Does Stop-Loss Order Mean?
In simple words, Stop-Loss Order is an order placed with a broker to sell a share/security when it reaches a certain price as per the risk taking capacity of the investor. A stop-loss order is designed to limit an investor’s loss on a security position. It is solely decided as per the investors choice.

It is also known as a “stop order” or “stop-market order”.

Stop-Loss Order Explained:
Taking an example here, you set a Stop-loss order of 10% on a share. Now, setting a stop-loss order for 10% below the price you paid for the stock will limit your loss to 10% as the share will be sold at the stop-loss price as set by you. This strategy allows investors to determine their loss limit in advance, preventing emotional decision-making and repending later.

For example, let’s say you just purchased shares for Mahindra Satyam at Rs.120 per share. Right after buying the stock you enter a stop-loss order for Rs.100. This means that if the stock falls below Rs.100, your shares will then be sold at the prevailing market price.

When the stock fall considerably even below this set stop-loss order, you can again enter into the stock and make fresh positions. This is a very wise decision to make as here, losing some amount of money once, gives you a chance to earn even more. This not only covers your initial loss that you incurred in the very first instance but in addition, earns a good profit for you.

Positives and Negatives
The advantage of a stop order is that you don’t have to monitor on a daily basis how a stock is performing. This is especially handy when you are on vacation or in a situation that prevents you from watching your stocks for an extended period of time. In this case, you simply place a stop-loss order with the broker and when the stock price reaches this limit, it will be sold by the system on your behalf, minimizing your losses to a certain limit.

The disadvantage is that the stop price could be activated by a short-term fluctuation in a stock’s price. The key to this is picking a stop-loss percentage that allows a stock to fluctuate day to day while preventing as much downside risk as possible. Setting a 5% stop loss on a stock that has a history of fluctuating 10% or more in a week is not the best strategy. You’ll most likely just lose money on the commissions generated from the execution of your stop-loss orders.

There are no hard and fast rules for the level at which stops should be placed. This totally depends on your individual investing style: an active trader might use 5% while a long-term investor might choose 15% or more.

Another thing to keep in mind is that once your stop-loss price is reached, your stop order becomes a market order and the price at which you sell may be much different from the stop price. This is especially true in a fast-moving market where stock prices can change rapidly.

A last restriction with the stop-loss order is that many brokers do not allow you to place a stop order on certain securities.

Advantages of the Stop-Loss Order
First of all, the beauty of the stop-loss order is that it costs nothing to implement. Your regular commission is charged only once the stop-loss price has been reached and the stock must be sold. You can think of it as a free insurance policy.

Most importantly, a stop loss allows decision making to be free from any emotional influences. People tend to fall in love with stocks, believing that if they give a stock another chance, it will come around. This causes procrastination and delay, giving the stock yet another chance. In the meantime, the losses mount.

No matter what type of investor you are, you should know why you own a stock. A value investor’s criteria will be different from that of a growth investor, which will be different still from an active trader. Any one strategy may work, but only if you stick to the strategy. This also means that if you are a hardcore buy-and-hold investor, your stop-loss orders are next to useless.

The point here is to be confident in your strategy and carry through with your plan. Stop-loss orders can help you stay on track without clouding your judgment with emotion.

Finally, it’s important to realize that stop-loss orders do not guarantee you’ll make money in the stock market; you still have to make intelligent investment decisions. If you don’t, you’ll lose just as much money as you would without a stop loss, only at a much slower rate.

Conclusion
A stop-loss order is a simple tool, yet so many investors fail to use it. Whether to prevent excessive losses or to lock in profits, nearly all investing styles can benefit from this trade. Think of a stop loss as an insurance policy: you hope you never have to use it, but it’s good to know you have the protection should you need it.