What is Stop-Loss Order (Stop Order)?
Stop-loss order is an advanced version of computer activated trade tool which is mostly allowed by brokers so that the trade is executed for a particular stock if only the predetermined price-levels are obtained while trading and such type of orders are designed only for minimizing the investors’ loss burden. This order ensures a high probability of the investor to achieve a predetermined entry price or exit price. This is used by investors as it helps them to limit the losses and lock in the profits. Once this price crosses the determined entry point or exit point the stop order converts into a market order.
Method for Calculating Stop-Loss Order
#1 – Percentage Method
Let us consider you are comfortable with losing 10% of the value of your Apple’s share and consider that it is now trading at $100. Then you would set a stop-loss order at (100*10%) = 10=100 – 10 = 90
#2 – Support Method
The support method is based on technical indicators and also based on the current trend as the investor identifies a support level and places a stop-loss order at that price. For example, the investor considers the support method of the Apple stock to be $80. Then stop-loss order would also be set at this level.
#3 – Moving Average Method
The moving average method calculates the moving average typically for a longer period of time and then, on the basis of that, places a stop-loss order below that level. The moving average of Apple is at $80; then, in the moving average method, the stop order can be placed at $79.
Let’s assume you own a hundred shares of Apple, and you have bought the share at $100 per share. The expectation is that the share might reach $120 in the next month, but you do not want to take the risk of it going the other way.
You ask your broker to put a stop order at $90. In this case, if the stock goes up, all the profits will be realized by you. But if the stock goes down and touches $90, the order will automatically be market order and will be placed.
It is not necessary that the order will be placed at $90; it can also happen that it will be placed either $89 or at $91 based on the market conditions.
Example #2 – Portfolio
Your portfolio size is $1,00,000, and the risk you are willing to take is 1%. The total risk for your portfolio, which you are willing to take, is 1%, which sums the total amount to $1000.The position size is $12,500. This is the total amount of risk you are willing to take.
The stop-loss order is placed at 8%, and the current share price is $50. Considering the stop-loss order at 8%, the share price and the risk you are willing to take are at $46 per share. That is the total amount of loss per share at $4.
Instead of stop-loss, if the protection was on the gain, then at 20%, the total profit would have been $60. Similarly, at 30%, it would have been $65, and at 40%, it would have been $70.
This is how stop-loss or gains are calculated based on the total portfolio amount and the risk you are willing to take.
One important point to discuss before getting on to the advantages of a stop order is that the advantage to one trader could be a disadvantage to others.
- Monitoring: The most vital advantage of a stop order is that it does not have to be monitored. The investor does not have to check continuously how the stock is performing. This is useful in situations where the investor is on a vacation or any action that prevents him from checking on the stocks for an extended period of time.
- Protection from Downside: When the prices fall, a stop order helps the investor to lock in losses and prevents the investor from incurring additional losses.
- Known risk: stop-loss order works at a predetermined price, and thus the investor knows how much risk is he/she going to take if they incur losses. This is important for money management. The investor can also figure out the risk-reward ratioThe Risk-reward RatioThe risk-reward ratio is the measure used by the investors during the trading for knowing their potential loss to the potential profit. Hence it is used by the traders for effectively managing their risk and capital during the trading process.. This ratio helps in calculating the risk you are willing to trade for the potential profit.
- Cost: There is no additional cost to make a stop-loss order. The commission is charged only when the price has reached. Then the order converts into a market order, and the purchase/sale is completed.
- Objective: These orders help in eradicating the financial bias and lets the investors trade on investment goals rather than an emotional attachment.
- Volatile Market/ Market Fluctuations: The stop price is a predetermined price. When the market is volatile, the stop price could be activated when it was not intended to because of the short term fluctuations.
- Price Guarantee: As discussed above, once the stop-loss order is activated, it becomes a market order. In case when the market is falling rapidly, there is no guarantee that the losses will be locked at the predetermined price. It will be different, and the losses will be higher than expected.
- Stop-loss orders can trigger a rapid sell-off of securities at the times of market crash. They have contributed to rapid sell-off and the stock market crashStock Market CrashA stock market crash occurs when stock prices in all sectors begin to fall rapidly. It is often the result of global factors such as war, scam, or the collapse of a certain industry. In such a crash, panic acts as a catalyst. in 2008. As the prices began to fall in October 2008, stop loss was triggered. This flooded the market with sell orders, which made the prices decline further. When the demand outpaces supply, prices tend to fall rapidly. The cycle of falling prices and triggering of the stop loss will add to the steepness in case of a market decline.
This has been a guide to what is Stop-Loss Order and its definition. Here we discuss how to calculate Stop Order to buy/sell stocks along with examples, advantages, and disadvantages. You can learn more about financing from the following articles –