What is Stop-loss order: Hi, legendary investor, Warren Buffett always say that you should follow 2 rules while investing. The first rule is to never lose your money. The second rule is never to forget rule no. 1. In investing and trading game, we can survive for a long period when we can save our capital. To save our capital, you can use stop-loss orders.
In today’s post, we will discuss what is stop-loss order and how can investors minimize their risk by using it.
Definition of Stop-loss order
A Stop-loss order is an order after which if the stock touches a certain price, it will be sold automatically. When stock price touches a certain price, a market order is immediately executed and our stocks are sold. For example, if an investor buys a share at Rs.25 per share, he wouldn’t want to bear a loss of more than Rs.5 per share.
Then that investor can put a stop-loss order at Rs 20 per share. As soon as the stock price will reach Rs.20, the share will be sold automatically. Whenever the prices fluctuate rapidly, then, in that case, a stop-loss order can be helpful for you. Now we have understood what is stop-loss order and why is it used. But whenever we talk about stop loss, investors confuse it with stop-limit order.
Difference between Stop loss order and Stop limit order
By the way, the purpose of both are almost the same, but they have a small difference. As we discussed, in a stop-loss order, when the stock price hits the trigger price, then a market order is executed. Our stock is sold. In stop-limit order, when the stock price hits trigger price, then our sell order becomes a limit order. Is there any difference? Yes, the market order is executed immediately while the limit order is executed as the stock price crosses the limit price.
Let’s understand both orders with a simple example. When we had put Rs20 stop loss, after this if the stock price goes below Rs.20, our stock price will be sold at market value. Suppose, if the stock price goes from Rs.25 to Rs.21, and then to Rs.17, the ln our stock will be sold at Rs.17. But in stop-limit order, it doesn’t happen. In stop-limit order, when the stock price falls below Rs.20, our limit order will activate. If we have put a stop-limit order, it ensures that the stock won’t be sold below Rs.20. This will be sold at or above Rs.20 only. Yes, it may happen that below Rs 20, the stock price may not touch Rs.20.
In this case, the limit order won’t be executed. So the difference is that when the stock price will go below Rs 20, the stop loss order will always be executed. But a stop-limit order doesn’t need to be executed. The main purpose of a stop-limit order is that many times stock price falls a lot below the limit order at which investors don’t want to sell. Investors want that when the stock price comes up again and hits the limit price, then their stock should be sold. In this case, a stop-limit order is useful. We have understood the difference between stop loss and stop-limit order.
Also Read: What Does Equity Mean?
Advantages of a Stop-loss order
Now we will understand, the advantages of a stop-loss order. The biggest benefit is that reduces your risk, and saves you from big losses in the stock market. The second benefit is that it has no emotions attached to it. In emotions, investors try to give a second chance to bring their stocks at profit. But due to this delay, investors have to face heavy losses.
So the stop loss saves you from emotional attachment and helps you exit from the stock at the right time. The third benefit is that the stop-loss order reduces losses but also helps you lock your profits. Suppose you bought a stock at Rs.100 per share. Then its price comes to Rs.150. You expect the prices to rise, also you want to lock profits. In this case, you can put Rs.140 as a stop-loss order.
After this, if the stock price goes below, you will be able to earn Rs.40 profit. The other benefit is that after a stop-loss order, you don’t have to actively track your stock. So these were a few benefits of a stop-loss order. Now let’s talk about the disadvantages of a Stop-loss order.
Disadvantages of a Stop-loss order
The biggest drawback is that due to short-term fluctuation, the stop-loss order will be activated and your stock will be sold. So it’s very important at what price are you setting the stop-loss. For example, an active trader can set his stop-loss at 5%. But for a long-term investor, it can be more than 15%.
Its second disadvantage is that your stock may be sold for a lower price due to stop-loss. Like we saw that your stock may get sold at Rs.17 also. To avoid this, you can use a stop limit as well. The risk in stop-limit is that many times your order is not executed.
So we discussed what is stop-loss and how is it beneficial for investors. A stop-loss order can save you from heavy loss and you can exit from the stock at the right time. Also, you can lock your profits with it. It is useful for both intra-day traders and long-term investors.