What is stop loss and how to use it: Contrary to investing, trading requires buying and selling assets on a short-term basis, and with it comes a huge flow of emotions. Emotions like fear, greed, anger, and disappointment can influence the way an individual may take his investing decisions. This can expose an individual to take unwanted market risks and can result in a significant loss of capital.
An individual should learn to control these emotions by maintaining discipline in the market. A simple way for an individual to maintain discipline and not fall victim to their emotions is maintaining stop-loss and targets.
In this article, we are going to take a look at the different aspects of what is stop loss and how to use it.
What is a Stop Loss?
It is an advanced order used to buy/sell an asset once the specific price is reached. This protects an individual from incurring excessive losses if the price rises/falls beyond a specific level.
Types of Stop-Loss orders
There are variations of stop-loss orders traders can place in the market to protect themself against their long positions and short positions.
Sell Stop Market Order
It is an order that is entered at a stop price below the existing market price. Traders use this order to protect themselves from incurring a loss when they buy a stock.
When the stocks that you have purchased, dip to the level of your stop loss, the target order gets activated and your long position will be exited at the available price.
Let us understand what a sell stop order is with the help of an example:
Suppose Mr. Nithin has bought 1,000 shares of company X at a price of Rs 100 per share. He has also set a stop loss at Rs 90.
If the shares of the company start dropping rapidly and reach the level of Rs 90 or below and stop order to sell is triggered and the order would be executed at Rs 90 or slightly lower.
Buy Stop Market Order
It is an order that is entered at a stop price above the market price.
Traders use this order to protect themselves from incurring a loss when they have sold or shorted the stock.
When the stocks that you have shorted rise to the level of your stop loss, the target order gets activated and your short position will be exited at the available price.
Let us understand what a buy-stop order is with the help of an example:
Suppose Mr. Nithin has sold/shorted 1,000 shares of company X at a price of Rs 100 per share. He has also set a stop loss at Rs 110.
If the shares of the company start rising and reach Rs 110 or above, the stop order to buy is triggered and the order would be executed at Rs 110 or slightly higher.
Trailing Stop Order
It is a stop loss order wherein the target price is adjusted at a fixed percent below or above the market price of a stock, depending on whether you have bought or sold a stock.
Here’s an example to explain trailing stop order:
Suppose, you have bought a stock for Rs 100 with a stop loss of Rs 90. Now, if the price of the stock moves to Rs 110, the stop loss will be trailed up to Rs 100, and so on as and how when prices move up.
This stop-loss method is used to protect you against a sudden decline in prices and also to protect the profit already made. This stop-loss strategy helps you to manage your risk and also provides protection for your profits.
Stop Limit Order
It is an order that combines the features of a stop loss order and a limit order.
When the stop price entered for a stock is reached, a stop-limit order becomes a limit order that will be executed at the specified price.
Let’s understand stop-limit order with an example:
Assume you bought 1,000 shares of a company at Rs 100 per share. You enter a stop-limit order with a stop price of Rs 90 and decide to specify a stop-limit price of Rs 88.
If the shares decline to the stop price of Rs 90, the 1000 shares of the company will be sold as long as a minimum price of Rs 88 is obtained. But if the price falls sharply below Rs 88, your order will remain unsold.
ALSO READ: What is a Stop-Loss Order? Types, Benefits & Limitations Explained!
How much should the Stop Loss and Target be?
Stop loss can be set depending on the risk appetite of an individual. But, if one sets the stop loss far, there’s a chance that you’ll end up losing a lot of money.
At the same time, traders who set the stop loss too close to the buying/ selling price, lose money stop loss has a chance of getting triggered at the small movement of prices against their view or position.
An individual can keep a stop loss using support or resistance levels of stock, wherein, if the stock crosses the support or resistance line, the stop loss is triggered. This method can be a little tricky for beginners, as it is difficult to determine the support and resistance level
Another simpler method an individual can use to decide to stop loss is to assign a percentage of the stock price they are prepared to lose before exiting the trade.
As for the targets/gains an individual wants to achieve, it should be 1.5 times the stop loss percentage. The targets can also be higher depending on the returns expectation of the individual, provided it is on a trailing stop order, which can limit losses and also lock in profits.
Conclusion
The stock market can provide an investor with an opportunity to create a huge amount of wealth. But an individual should not be hasty and try to generate money quickly. This can result in losing more money than one is generating.
Along with having good fundamental and technical knowledge of the stock market, mastering one’s emotions and maintaining discipline is also an important part of a trader’s success.
It takes practice to maintain discipline in the stock market and applying simple things like stop-loss and targets can take you a long way.
Hope you have gained more insight into trading by reading this article on what is stop loss and how to use it.
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