CHAPTER 6A : Trading Strategies - Why put a Stop Loss?

What Is a Stop-loss Order?

It is an order placed with a broker to buy or sell once the stock reaches a certain price. The purpose of a stop-loss is to limit a trader's/investor's loss on a script. Example – A trader purchased SBI at Rs. 300 per share and put a stop-loss order for Rs. 295. According to the trade, if the stock price falls below Rs. 295, his shares will be sold at the market price. DreamGains suggests to always trade with a Sop-loss.

Benefits

1. The benefit of a stop-loss order is that you don't have to monitor on a continuous basis about how a particular script is trading in the market. On a lot of occasions (example – you are in a meeting or on a vacation), it will not be possible for you to keep a track of your positions.
2. Stop-loss orders are also used to book profits. In such cases, the stop-loss order is set at a price/percentage level below the current market price (which is in profit at current level). The stop-loss levels can be changed as the script price fluctuates. Using a stop-loss for this purpose allows traders and investors to run in profits while guaranteeing that they book at least some profits in case the stop-loss triggers. Example – In our SBI example, let’s say that the current market price has reached to Rs. 315 (i.e. Rs. 15 profit per share). A trader can then (according to his judgment) put a stop-loss at Rs. 310, so that even in case the prices fall down, he will book at least Rs. 10 profit per share. This helps the trader remain bullish on the script; while safe-guarding his profit in case a dip in prices occurs.
3. A stop-loss order costs nothing to be placed. Brokerage is charged only once the stop-loss triggers and the stock is sold.
4. Also, a stop-loss allows the traders/investors to take decisions without any emotional influences. A general tendency of people is to keep believing that if they give their script another couple of days/months, it will rebound to its original price. This, in a majority of cases causes further losses to traders/investors.

Disadvantages

1. The disadvantage of a Stop-loss Order is that the SL (Stop-loss) price could be triggered by a short-term movement in a stock's price. The art lies in selecting a stop-loss that allows your script to fluctuate in small ranges on a daily basis while preventing the risk of getting triggered. There are no strict rules for the levels at which the stop-loss should be put. This completely depends on a trader’s trading strategies and style - an active trader might use 5% while a long-term investor might choose 10% or more and some risky traders/investors might choose more than 20% also.
2. When a stop-loss is triggered, the stop-loss order becomes a market order and the price at which your position exits may be much different from the stop-loss price. This becomes more of a risk in a fast-moving market.
3. Yet another disadvantage of a stop-loss order is that in a lot of cases, brokers do not allow to place a stop-loss order on certain scripts.

A stop-loss order is thus a simple strategy, yet there are only a few traders/investors who use it. A stop-loss order is to safe-guard a trader’s/investor’s interests. You hope you never have to use it, but it's always good to know that you have the protection in case you need it.

About DreamGains

DreamGains Financials India Private Limited formed in 2004 as an independent and privately owned company is build upon the principles of teamwork and partnership.It is a trusted name in the financial service arena and provides you with an entire gamut of services under one roof. It today has emerged as a premium Indian stock consultancy, with an absolute focus on business and a commitment to provide “Real value for money” to all its clients.