It is an order placed with a broker to buy or sell once the stock reaches a certain price. A stop loss is designed to limit an investor's loss on a security position. Setting a stop loss order for 10% below the price at which you bought the stock will limit your loss to 10%. For example, let's say you just purchased RELIANCE at Rs.500.00 per share. Right after buying the stock you enter a stop loss market order for Rs. 450.00. This means that if the stock falls below Rs. 450.00 per share your shares will then be sold at the prevailing market price.
Positives and Negatives
The advantage of a stop order is you don't have to monitor on a daily basis how a security is performing. This is especially handy when you are on vacation or having a full time job that prevents you from watching your security for an extended period of time.
The disadvantage is that the stop price could be activated by a short-term fluctuation in a securities price. The key is picking a stop-loss percentage that allows a security to fluctuate day-to-day while preventing as much downside risk as possible. Setting a 5% stop-loss on a security that has a history of fluctuating 10% or more is not the best strategy: you will 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 price is reached, your stop order is a market order, 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.
Not just for Preventing Losses
Stop loss orders are traditionally thought of as a way to prevent losses. (After all, it's called a "stop loss" for a reason.) Another use of this tool, though, is to lock-in profits, in which case it is sometimes referred to as a trailing stop.
In all forms of long-term investing and short-term trading, deciding the appropriate time to exit a position is just as important as, if not more important than, determining the best time to enter into your position. Buying (or selling, in the case of a short position) is a relatively less emotional action than selling (or buying, in the case of a short position). When you enter a position, the potential for realized profits is but a dream and the possibility of losses is only a vaguely considered nightmare.
By contrast, when it comes time to exit the position your profits are staring you directly in the face, but perhaps they are telling you that there is potential for even greater profitability if you were just to ride the tide and exercise a little bit more patience. In the unthinkable case of paper losses, your heart tells you to hold tight, to wait until your losses reverse and the passage of time brings you into a profitable position once again.
But such emotional responses are hardly the best means by which to make your selling (or buying) decisions. They are purely unscientific, and the presence of emotion brings you as far from a disciplined trading system as can be imagined.
Trailing Stop-Loss
The most basic technique for establishing an appropriate exit point is the trailing stop technique. Very simply, the trailing stop maintains a stop-loss order at a precise percentage below the market price (or above, in the case of a short position). The stop-loss order is adjusted continually based on fluctuations in the market price, always maintaining the same percentage below (or above) the market price. The trader is then "guaranteed" to know the exact minimum profit that his position will garner.
Here, the stop-loss order is set at a percentage level below not the price at which you bought it but the current market price. The price of the stop loss adjusted as the stock price fluctuates. Remember, if a stock goes up, what you have is an unrealized gain, which means you don't have the cash in hand until you sell. Using a trailing stop allows you to let profits run while at the same time guaranteeing at least some realized capital gain.
To use our Reliance example from above, say you set a trailing stop order for 10% below the current price, and the stock skyrockets to Rs. 800.00 within a month. Your trailing stop order would then lock-in at Rs.720.00 per share (Rs.800 - (10% x Rs.800) = Rs.720). This is the worst price you would receive, so even if the stock takes an unexpected dip, you won't be in the red.
Limiting Losses
It is simply not possible for any trader--whether amateur, professional or anywhere in between--to avoid every single loss. The disciplined trader is fully cognizant of the inevitability of losing hard-earned profits and, as such, is able to accept losses without emotional upheaval. At the same time, however, there are systematic methods by which you can ensure that losses are kept to a minimum.
A 2% Limit of Loss
A common level of acceptable loss for one's trading account is 2% of equity in the trading account. The capital in your trading account is your risk capital, the capital that you employ (that you risk) on a day-to-day basis to try to garner profits for your enterprise.
The loss-limit system can even be implemented before entering a trade. When you are deciding how much of a particular trading instrument to purchase, you would simultaneously calculate how much in losses you could sustain on that trade without breaching your 2% rule. When establishing your position, you would also place a stop order within a maximum of 2% loss of the total equity in your account. Of course, your stop can be anywhere from a 0% to 2% total loss. A lower level of risk is perfectly acceptable if the individual trade or philosophy demands it.
Every trader has a different reaction to the 2% rule of thumb. Many traders think that a 2% risk limit is too small and that it stifles their ability to engage in riskier trading decisions with a larger portion of their trading accounts. On the other hand, most professionals think that 2% is a ridiculously high level of risk and prefer losses to be limited to around half or one-quarter of a percent of their portfolios. Granted, the pros would naturally be more risk averse than those with smaller accounts--a 2% loss on a large portfolio is a devastating blow. Regardless of the size of your capital, it is wise to be conservative rather than aggressive when first devising your trading strategy.
Monthly Loss Limit of 6%
So, you have now established a system whereby your loss from each individual trade is limited to 2% of your risk capital. But it doesn't take a rocket scientist to realize that even losing a moderate 1% of your account's value in ten days within a month results in a rather devastating 10% of your account's value within that month (notwithstanding any profits that you might have made in the other twelve-odd trading days within the month). In addition to limiting losses from individual trades, we must establish a circuit breaker that prevents extensive overall losses during a period of time.
A useful rule of thumb for overall monthly losses is a maximum of 6% of your portfolio. As soon as your account equity dips to 6% below that which it registered on the last day of the previous month, stop trading! Yes, you heard me correctly. When you have hit your 6% loss limit, cease trading entirely for the rest of the month. In fact, when your 6% circuit breaker is tripped, go even further and close all of your outstanding positions, and spend the rest of the month on the sidelines. Take the last days of the month to regroup, analyze the problems, observe the markets, and prepare for re-entry when you are confident that you can prevent a similar occurrence in the following month.
How do you go about instituting the 6% loss-limiting system? You have to calculate your equity each and every day. This includes all of the cash in your trading account, cash equivalents, and the current market value of all open positions in your account. Compare this daily total with your equity total on the last trading day of the previous month and, if you are approaching the 6% threshold, prepare to cease trading.
Employing a 6% monthly loss limit allows the trader to hold three open positions with potential for 2% losses each, or six open positions with a potential for 1% losses each, and so forth.
Making Necessary Adjustments
Of course, the fluid nature of both the 2% single trade limit and the 6% monthly loss limit means that you must re-calibrate your trading positions every month. If, for example, you enter a new month having realized significant profits the previous month, you will adjust your stops and the sizes of your orders so that no more than 2% of the newly calculated total equity is exposed to a risk of losses. At the same time, when your account rises in value by the end of the month, the 6% rule of thumb will allow you to trade with larger positions the following month. Unfortunately, the reverse is also true: if you lose money in a month, the smaller capital base the following month will ensure that your trading positions are smaller.
Both the 2% and the 6% rule allow you to pyramid, or add to your winning positions when you are on a roll. If your position runs into positive territory, you can move your stop above break-even and then buy more of the same stock--as long as the risk on the new aggregate position is no more than 2% of your account equity, and your total account risk is less than 6%. Adding a system of pyramiding into the equation allows you to extend profitable positions with absolutely no commensurate increase in your risk thresholds.
Why is a Stop Loss Order recommended?
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. It's like a free insurance policy!
Secondly, but most importantly, a stop-loss allows decision making to be free from any emotional influences. People tend to fall in love with stocks; we believe that if we give a stock another chance, it will come around. This causes us to procrastinate and delay, giving the stock yet another chance and then yet another. 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. If you plan on holding a stock for the next decade there is no reason to place a stop. The point here is to be confident in your strategy and carry through with your plan. Stop-loss orders help us stay on track without clouding our 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 or trading 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
The 2% and the 6% rules of thumb are highly recommended for all traders, especially those who are prone to the emotional pain of experienced losses. If you are more risk averse, by all means, adjust the percentage loss limiters to lower numbers than 2% and 6%. It is not recommended, however, that you increase your thresholds--the pros rarely stray above such potential for losses, so do think twice before you increase your risk thresholds.
A stop loss order is such a simple little tool, yet so many traders 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 if you need it.
This article is to brief you about stop-loss, their uses, advantages and disadvantages.
