Stop Loss: Its Benefits and How to Use It

Stock brokers in India offer various tools and advantages for trading in the stock market. With the advancement of technology, trading can be done from anywhere and at any time, with orders executed in just a few clicks. One such tool is the stop loss, which allows traders to buy or sell stock at a desired price. This tool helps traders manage risk and close their positions before incurring significant losses. By setting price limits with a stop loss order, investors can establish clear boundaries for potential losses and protect their investments. Learning to use this tool effectively can enhance trading strategies and minimise risks in the stock market.

Defining a Stop Loss Order in the Share Market

A stop loss order enables position closure at a predetermined price, allowing traders to specify the trigger price for order execution. This order type serves various trading purposes, including intraday trading, equity, and derivatives, offering flexibility to set stop loss levels based on individual trades. In the share market, two types of stop loss orders exist.

Limit Order

In a stop loss limit order, traders set both the trigger price and a specific exit price to manage trades effectively. The order is sent to the exchange once the trigger price is met but executes only when the limit price is reached. For instance, if a trader holds a short position on an X stock at ₹90 with a stop loss trigger at ₹90, and anticipates the stock to rise to ₹100 due to market volatility, the stop loss limit order will execute at ₹100 if the price reaches that level.

Market Order

This is a stop loss market order which means that the order will be executed at the next available price after the order is sent to the exchange.

Stop Loss Trigger Price

A trigger price is a prefixed price at which a buy or sell order will be executed. The stop loss trigger price means that the trigger price is set and hit, and the following order is shared with the stock exchange.

Using Stop Loss Order

• A stop loss order offers several advantages, requiring traders to plan proper points for its setup.
• It can be used in both long and short positions, allowing traders to place opposite orders to manage risks effectively.
• When setting up the trade, it’s essential to place the stop loss at appropriate support or resistance levels on the stock charts, avoiding proximity to the entry price to prevent premature execution.
• Considering one’s risk tolerance and potential rewards, setting the stop loss at a certain gap in the trade can be beneficial.
• A common rule is to set the stop loss price below 20% of the current asset price, ensuring a reasonable buffer against market fluctuations.
• Placing a stop loss demands discipline and an understanding of the stock market dynamics to execute effectively.
• For example, if purchasing Wipro shares at ₹500 per share, setting a stop loss order at ₹480 would trigger a sale if the stock price falls to or below that level, mitigating potential losses.

Benefits of Stop Loss Order

Some of the advantages of a stop loss order are as follows:

• Implementing a stop loss aids in minimising losses by guiding investors to place orders strategically, focusing on upward-performing stocks rather than those in a downtrend. 
• This automation tool ensures seamless execution of stock sales without manual intervention once configured correctly. 
• By pre-planning trades and assessing risk-reward ratios, traders can set stop losses at predetermined levels, such as 20% or 30% below the current share price. 
• This approach helps investors maintain emotional discipline and avoid impulsive decisions that could jeopardise their trades and potentially lead to losses.

Disadvantages of Stop Loss Order

• The major drawback of a stop loss is that when there are short term fluctuations in the share price, it can get activated and execute the trade.
• Another thing is that investors can make a call on whether to stay in the trade or not, but in intraday trader trade cannot go back or secure their position.
• Sometimes the broker may charge additional fees for the stop loss tool before using it to check the hidden charges of a broker.

Conclusion

The main objective of a stop loss order is to reduce risk and exposure and make trading less risky and more controlled. This automated system is a great help for traders who constantly invest in the stock market. Traders who have strong fundamentals and tend to make better decisions use this tool to get the best out of their trade. In short term trade, it’s quite risky to avoid a fall in the stock price, therefore having a stop loss in place will help one to make quick responses and save one from heavy losses.

Frequently Asked Questions (FAQs)