Stop Loss Meaning: What Is Stop Loss And Its Benefits (2024)

Investing in the stock market comes with risks. There are a host of safeguards available to investors today to not only understand the market but also invest well and manage risk well. Tools are essentially different orders you can place with your brokerage company to protect yourself like “take profit”, “boundary options”, “hedging” and “stop loss”. Let’s talk about how stop loss works.

Stop Loss Meaning

A stop loss is a type of order that investors or traders use to limit their potential losses in the stock market. It works by automatically selling a security when its price reaches a certain level, known as the stop price. This helps traders avoid larger losses if the price of the security continues to drop.

Stop loss orders play a crucial role in risk management in the stock market. Using a stop loss strategy, investors and traders can limit their potential losses which reduces the risk of holding a losing position. This helps in maintaining discipline and sticking to investment goals and strategies even in a volatile market condition.

Most of our decisions are based on our emotions but in the stock market, these emotions can mean financial ruin. Stop loss orders can help investors manage these emotions and avoid making impulsive decisions based on fear or greed. By setting a predetermined exit point, they can reduce the emotional stress of monitoring their investments and make rational decisions based on their investment plan.

An investor researches and sets a limit as per the previous market performance of the share typically below the current market price for a long position or above the current market price for a short position.

In simple terms, you purchased shares of X company at INR 10 per share and entered a stop loss of INR 8 right after buying these shares. Now, if the stocks fall below INR 8, your purchased shares will be sold at the prevailing market price saving you from further losses.

How a Stop Loss Order Works

We all have seen the floating ball valve used in water tanks which automatically stops the water flow in the tanks when it reaches a certain level to stop overfilling or spillage. The very same way a stop loss order is a tool that automatically triggers the sale of a security when its price reaches a certain level, known as the stop price.

When an investor places a stop loss order, they specify a certain price, called the stop price at which the order will be triggered. If the price of the stock reaches the stop price, the stop loss order becomes a market order, which means that the stock will be sold at the best available price, which may be different from the stop price specified in the order.

This helps to limit potential losses in the event of a downward trend in the stock’s price. However, stop-loss orders do not guarantee that an order will be executed at the stop price and the actual price at which the order is executed may be different, especially during high market volatility.

Types of Stop Loss Orders

We have learned what a stop-loss order is and how it is important for an investor, now we will see the different types of stop loss orders. In general, there are two types of stop loss order:

Fixed Stop Loss Order

As the name suggests, a fixed stop-loss order is a type of stop-loss order where the stop price is set at a fixed level, typically a percentage below the market price. It allows investors to automatically trigger a sell order when the stock price reaches the predetermined stop price and limit the potential loss.

One advantage of fixed stop-loss order is we can set and remain at a constant level irrespective of the market volatility. Investors use this type of order to protect their investment and who prefer to set a constant stop-loss level.

Trailing Stop-Loss Order

This one is a little different from the previous one. Trailing stop loss order allows investors to set up a stop-loss level that adjusts to the price of the stock as it changes.

In simple words, a percentage is fixed which allows you to trail the growth of your share and set up a stop loss accordingly. If the price moves in a favourable direction, the stop-loss level also moves in that direction. This order helps to lock in profits while limiting potential losses in a declining market.

How to Set Stop Loss Levels

Factors to consider when setting stop loss levels

Volatility

The stop-loss should be set as per the volatility of a security. The more volatile a security is, the more important it is to have a stop loss in place

Liquidity of the stock

Some stocks trade on very thin volumes which means even if there is a stop loss in place, you may not be able to exit because there is no buyer on the other side. Therefore, buying illiquid stocks has its own set of risks, and using a stop-loss strategy becomes essential.

Position size

If you have a large position in a stock, executing it may be difficult for illiquid security. Therefore, only take positions that you feel comfortable with when you look at the size of that position vis a vis your net worth.

Determining the right stop loss level

Setting up a stop loss level is a subjective process that varies from individual to individual. A person with higher risk tolerance will set up the level a little low while on the other hand, an individual with low-risk tolerance will definitely set the stop loss level high.

One of the most popular methods of determining stop-loss levels is the percentage method. The method is very simple and effective, before setting up the stop-loss level the investor needs to determine the percentage of the stock price they are willing to give up before exiting their trade.

For example, an investor purchased a share for INR 100 and decided to set 10% of the loss to bear while exiting. So, he will set the stop loss limit from 90-100, which will limit his potential loss to 10% of the price.

Advantages of using stop loss

Traders consider a lot of factors while investing in the stock market. Stop loss is an effective tool that helps to reduce losses and make this decision-making process easier in the following ways:

Minimising Losses

Using stop loss orders, traders can protect their capital and ensure that they don’t experience large, irreversible losses that could put their trading account in jeopardy.

Improving Risk Management

Your portfolio will look good if you have more capital gain, by managing risk effectively and limiting losses, stop-loss orders can help traders improve their overall trading performance and achieve their investment goals.

Emotional Control

Being emotionally biassed is one of the major reasons for a bad decision-making process. Stop-loss orders take the emotion out of the decision-making process by automatically closing a trade when a predetermined level is reached. This helps traders avoid making impulsive or emotional decisions that could negatively impact their trading results.

Disadvantages of Using Stop Loss

Like every existing thing in the universe, stop loss has its negative side which one should be aware of. While stop-loss orders can be a valuable tool for managing risk, there are also some disadvantages to consider:

Slippage

The stock market is a very volatile space changing every second, the price of a security can gap past the stop loss level, leading to slippage. This means that the trade may be executed at a price that is significantly different from the stop loss level, resulting in larger losses than expected.

Guaranteed execution

The main objective of a stop loss is to limit losses but they do not guarantee whether a trade will be executed at the desired price. In volatile market conditions, the stop-loss order is executed at a much worse price which results in a higher loss.

Market gaps

There are certain gaps in the market that lead to failure of stop-loss in certain situations. For example, in markets with low liquidity, it can be difficult to execute a stop-loss order at the desired price again resulting in a loss.

Bottom Line

While stop loss orders have some loopholes to consider, it is the most valuable tool for managing risk and limiting losses. When you make decisions more rationally the market becomes an avenue for wealth creation and not gambling.