A Beginner’s Guide to Stop-Loss Orders: Meaning, Types, Pros, and Cons

Stop-loss orders are the easiest and simplest way to protect yourself from losses in a declining market. They can be applied to both bought and short-sold instruments and can be modified at any point during a single trading day since they are considered day orders. While they don’t guarantee profits, they can help limit your losses and keep your trading strategy on track.

In this article, we will cover what stop-loss orders are, how they work, their types, and their advantages and disadvantages.

What Are Stop-Loss Orders?

A stop-loss order is an order placed with a broker to sell a security when it reaches a certain price, designed to limit an investor’s loss on a position. 

Suppose you buy an instrument at INR 100 per unit with the expectation that its price will rise. However, you want to limit your potential loss if the price falls. You are not willing to take a loss of more than INR 5 per unit, meaning you don’t want to sell the instrument for less than INR 95.

In this case, you can place a stop-loss order at INR 95. If the price drops to INR 95, your stop-loss order will be triggered, and the instrument will be automatically sold at the next available price, which could be INR 95 or slightly different depending on the market conditions at the time.

So, the stop-loss order in this scenario is a sell order that helps ensure that your losses do not exceed INR 5 per unit.

How Do Stop-Loss Orders Work?

Stop-loss orders work by automatically selling (or buying) a security when its price reaches a pre-fixed level, limiting an investor’s potential loss on a position. An investor specifies a stop price at which they want the stop-loss order to trigger. Generally, a 7% stop-loss rule used by investors to limit their potential losses on their investments. According to this rule, if a stock price declines by 7% or more from its purchasing price, the investor should sell the stock.

For a long position (buying with the hope that the price will go up), the stop price is set below the current market price. For a short position (selling with the hope that the price will go down), the stop price is set above the current market price. 

The stop-loss order becomes active when the security’s price reaches the specified stop price. At this point, the stop-loss order converts into a market order (an order to buy or sell immediately at the best available current price). The market order is then executed by the broker. This price may be exactly at the stop price, higher, or lower, depending on market conditions and the speed at which the order is processed.

Types of Stop-Loss Orders

Standard Stop-Loss Order

A standard stop-loss order converts into a market order when the stop price is reached. Once the security’s price hits the specified stop price, the order is triggered and executed at the best available price. For example, you buy a stock at INR 200 and set a stop-loss at INR 195. If the stock drops to INR 195, the stop-loss order is triggered, and the broker sells the stock at the next available price, which could be INR 195 or slightly lower depending on market conditions. 

Trailing Stop-Loss Order

A trailing stop-loss order sets the stop price at a fixed percentage or an amount below (for long positions) or above (for short positions) the market price. As the price of the security moves in a favourable direction, the stop price adjusts accordingly, maintaining the set distance. If the price moves unfavourably, the stop price remains unchanged. For example, you buy a stock at INR 100 and set a trailing stop-loss with a 5% trail. If the stock rises to INR 110, the stop price adjusts to INR 104.50 (5% below INR 110). If the stock then falls to INR 104.50, the trailing stop-loss order is triggered and converted into a market order to sell. 

Advantages of Stop-Loss Orders

Stop-loss orders offer several benefits that can help investors manage risk. Here are the key advantages:

Automatic Execution: Stop-loss orders automatically trigger once the set price is reached. They provide safety against major losses without the need for constant portfolio monitoring. 

Protection Against Losses: By setting a stop price, investors can limit their potential losses to a specific amount. 

Market Independence: Stop-loss orders save you the pain of keeping track of and acting on a fast-changing market, as the stop-loss order will automatically execute once the stop price is reached.

Discipline: Stop-loss orders promote a disciplined approach to trading by ensuring that losses are cut at predetermined levels, preventing hasty decisions. 

Disadvantages of Stop-Loss Orders

Here are some of the potential disadvantages of stop-loss orders:

Whipsawing: In volatile markets, prices can quickly fluctuate above and below the stop price. It may result in frequent triggering of stop-loss orders, which may lead to increased trading costs and reduced returns.

Selling Stocks Too Soon: Stop-loss orders can lead to premature selling of stocks. It may result in cutting short potential gains if the market rebounds after a temporary dip.

Expensive Service: Brokers may charge different commissions and fees for executing stop-loss orders, adding to the overall cost of trading. 

Over-Reliance on Automation: Relying solely on stop-loss orders for risk management may lead to a lack of active monitoring and adjustment of investment strategies. It may not be ideal in the long run. Besides stop-loss orders, one can use other risk management strategies like diversification, position sizing and hedging.

Stop-Loss Order vs. Stop-Limit Order

Stop-loss orders and stop-limit orders are both tools used by investors to manage risk in trading. A stop-loss order is placed to automatically sell a security once its price reaches a specified trigger level, known as the stop price. On the other hand, a stop-limit order is placed to sell a security once its price reaches a specified trigger level (stop price), but only if it can be executed at a specified limit price or better.

While stop-loss orders offer automatic execution, they may result in selling at prices much lower than the stop price in fast-moving markets. In contrast, stop-limit orders provide price control, but there’s a risk of the order not being executed if the market price does not reach the limit price.

Ultimately, the choice between the 2 depends on an investor’s risk tolerance, trading strategy, and market conditions. 

Conclusion

A stop-loss order is an order to sell a security when its price reaches a certain level. It is a great risk management technique used by investors. However, stop-loss orders require careful consideration. It’s a judgement call that should align with your personal capacity to handle risk. However, once you are aware of the potential risks, you can carefully use stop orders to invest automatically and efficiently.

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FAQs

Why do you need a stop-loss order?

A stop-loss order is important for managing risk in trading. It provides investors with a predetermined exit point for their positions, helping to limit potential losses in volatile market conditions. 

What is an example of a stop-loss order?

Suppose an investor purchases a stock at INR 50 per share and sets a stop-loss order at INR 45. If the stock price falls to INR 45 or below, the stop-loss order automatically triggers, and the stock is sold at the current market price. It limits the investor’s potential loss.

What is the difference between a limit order and a stop-loss order?

The main difference between a limit order and a stop-loss order lies in their execution and purpose. A limit order specifies the price at which an investor is willing to buy or sell a security. It is executed only at the specified price or better. In contrast, a stop-loss order triggers a market order to buy or sell a security once its price reaches a specified level, known as the stop price. 

What is the 7% stop-loss rule?

The 7% stop-loss rule is a common risk management strategy used by investors to limit their potential losses on their investments. According to this rule, if a stock price declines by 7% or more from its purchasing price, the investor should sell the stock.

What is trailing stop-loss?

A trailing stop-loss order is a type of stop-loss order that adjusts the stop price as the market price of a security moves in a favourable direction. It is set at a fixed percentage or amount below (for long positions) or above (for short positions) the market price. As the market price increases, the trailing stop price moves up accordingly, maintaining a set distance. If the market price moves against the investor, the stop price remains unchanged.