Investors give a broker a stop-loss order to sell a particular stock once it reaches a price. A stop-loss is intended to reduce the investor's loss on an investment in a security. By placing a stop-loss order 10% below the stock's purchase price, you can keep your loss to that amount. To comprehend the stop-loss concept, think about the following example.

Consider buying shares of Reliance Industries for INR 2,000 each. After purchasing the stock, you program a stop-loss order for INR 1,800. The broker will sell your shares at the going market if the stock drops below INR 1,800.

Fortunately, stop-loss orders are automated and don't require human input, thanks to the development of technology.

What is a Stop Loss Order?

A stop-loss order enables users to automatically square off their position at a predetermined price when they are in a losing trade. Stop-loss orders are used in intraday, stock, and derivatives trading. 

Both sides of the position you take allow for the usage of stop-loss orders. To limit your losses, you can create a buy or sell stop-loss order depending on whether you are in a long or short position.

What are the Types of Stop Loss Orders?

There are two types of stop-loss orders:

1. Limit Order

 A stop-loss limit order lets you choose the price at which you'll sell a position if it moves in the other direction. Once this price is reached, the order will be squared off with limited losses.

Let's use an example to better understand this. A trader starts shorting an X stock at Rs. 100 with an Rs. 90 target price. However, given the market's unpredictable nature, he anticipates that the stock may also increase to Rs. 110. There is a wide range of pricing. 

He placed a stop-loss limit order at Rs. 103, considering this. Now, if prices increase rather than decline as the trader had predicted, the stop-loss limit order will be carried out when it reaches Rs. 103. After that, if the market keeps rising, the trader can limit its losses drastically.

2. Market Order

With a stop-loss market order, the order will be filled at the following price after confirmation.

Let's use the same scenario to better understand a stop-loss market order. The trader opened a short position at 100 rupees and set a market-based stop loss at 104. The work will be squared off at the following price when the share's current market price reaches Rs. 104.

How Do Stop Loss Orders Work?

A stop-loss order is a tool traders and investors can use to control their losses and safeguard their gains. It allows them to manage risk by putting a stop-loss order, which allows them to exit a position if the price of their security begins to move in the opposite direction from the work they have done.

A customer order, known as a stop-loss order to sell, directs a broker to sell a security if its market price falls to or below a predetermined stop price. A purchase stop-loss order places the stop price above the market's going rate.

What is the Purpose of a Stop Loss Order?

 A stop-loss order's primary goals are to lessen risk exposure (by reducing prospective losses) and facilitate trading (already having an order in place that will automatically be executed if the market trades at a specified price).

To reduce risk and avert a potentially disastrous loss, traders are strongly advised to always utilize stop-loss orders when entering a trade. Stop-loss orders lessen the risk associated with trading by capping the amount of money at stake on any given deal.

Advantages of Using Stop Loss Order

Here are a few advantages that every investor knows while using the stop-loss concept:

1. Minimizing Losses

• A stop-loss order's main benefit is that it minimizes losses and guards against significant losses in the stock market. As a result, several investors failed to place a stop order when prices were falling quickly and things were looking bad.
• Therefore, a stop-loss order will protect these investors from significant stock market losses.

2. Serves as a Tool For Automation

A stop-loss order is an automation tool that immediately sells your shares when the price drops below the predetermined level. Once the stock reaches the predetermined price, the stop loss will automatically trigger, eliminating the need for constant portfolio monitoring.

3. Keeps Risk and Reward Balanced

• Maintaining risk and reward is crucial when dealing with the stock market. Investors should only assume a specified amount of trouble if they hope to earn a specific bonus.
• For instance, they must decide if they will accept 5%, 20%, or 50% of the loss in exchange for that much profit. Using a stop loss may keep their risk and reward in check.

4. Encourages Self Control

 Investors should avoid letting their emotions interfere with their stock market investments. Stop-loss orders encourage disciplined trading and help them stay motivated in their financial planning and methods.

Disadvantages of Using Stop Loss Order

Along with the benefits of stop-loss orders, there are also a few drawbacks that every investor should be aware of.

1. Transient Variation

• The primary and biggest drawback of utilizing stop-loss orders is that they might activate during short-term price changes in shares, which increases the risk for investors.
• Every investor needs to remember that choosing a stop-loss order should allow the stock to move and carry the least risk.

2. Too Soon Stock Sales

The only danger associated with using the stop-loss order tool is being forced to exit a trade that could have generated a more significant profit if the investor had been willing to accept a more meaningful and higher level of risk. Stop loss limits an investor's ability to benefit by closing deals too quickly.

3. Investors Must Determine Stock Prices

Investors using stop-loss must choose what price to establish while stocks decline. Investors must navigate a challenging phase of the process, but they can get assistance from financial experts by using their relationships.

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How to Read Stop Loss Orders?

The simplest way to comprehend a stop-loss order is to consider it an essential order instead of your trade position. Let's clarify with a few examples.

• If you purchase a stock expecting it to increase in value, it begins to decline instead. As a result, you can foresee this and place a stop loss order at a price where your losses will be under control.
• A stop-loss order also allows you to quit the trade with a loss. Although this loss is somewhat limited, it could have been worse if a stop-loss order hadn't been put in.
• Although a stop-loss order is always advised while trading, it's crucial to choose the right price to place it. Before deciding the price for your SL order, you should examine the charts and note the support and resistance levels.

Examples of Stop Loss Order

A trader places a stop-loss order at $90 and pays $100 for 100 shares of XYZ Company. Over the coming weeks, the price falls and dips below $90. When the trader's stop-loss order is activated, the position is sold at a slight loss of $89.95. The market's negative trend is still present.

A trader places a stop-loss order of $90 and pays $100 for 500 shares of ABC Corporation. The company releases poor earnings numbers after the market has closed. The following day, when the market opens, ABC's stock price gaps lower. 

A stop-loss order placed by the trader is triggered. The order is filled at $70.00, resulting in a sizable loss. However, the market keeps falling and ends the day at 49.50. Although the stop-loss order couldn't fully protect the trader, it nonetheless kept the loss far lower than it otherwise might have.

What is the Procedure For Placing Stop Loss Orders?

Understanding the stop-loss technique, or how to set the stop loss, comes after you fully grasp the stop-loss concept. I'll begin with a straightforward example. You purchased 1000 shares of stock for Rs.145. 

According to the technical chart, the store has good support at Rs. 135. The stop loss should preferably be set below Rs. 135 so that you can record a loss and sell the stock if the underlying trend changes. You don't want to lose more than Rs. 6,000 on the transaction. 

What ought you to do? The straightforward stop-loss method, in this case, is to place your willingness to accept a loss first and the technical levels second.

In this instance, you might have either waited for the stock to decline by Rs. 4 before starting the trade or, if you have started it, kept the stop loss at Rs. 139 despite the support level of Rs. 135 in place. In the end, affordability triumphs.

We have now reached the halt loss steps. You should place a stop-loss order in the opposite direction of the original order because stop-loss is also an order. 

Thus, if you are making a buy order, your stop loss order must be a sell order, and vice versa if you are placing a sell order. Choosing between a market stop loss and a limit stop loss is the next step in the stop loss placement process. Let's take a closer look at the procedure.

Example

Consider purchasing 1000 shares of REC Ltd at Rs. 200 with a maximum loss tolerance of Rs. 5,000. Place your stop loss at Rs. 195. If the stock drops to Rs. 195, the stop loss is activated, and your trade is closed. 

Yes, you suffered a loss, but keeping it to just Rs. 5,000 could preserve your cash. There will be brokerage and statutory charges, but you can plan for them because they are known. Always consider the total cost.

Stop loss is a sell order you set when you place a buy order to prevent failure when you believe the prices may move against you.

Setting a Stop Loss for a Buy Trade

Suppose you purchased a stock for Rs. 250 but decide not to hold it if it drops to Rs. 244. A standard stop loss (SL) order and a stop loss with a market order (SL-M) will operate similarly.

You can place a "Sell SL-M order" in SL-M orders and set the order's trigger price at Rs. 244. The SL-M order will be submitted to the exchange, and the position will be squared off at market price if the stock reaches Rs. 244. Due to liquidity, or lack thereof, your actual execution may be a few bids away.

Let's now discuss SL orders or entire Stop-Loss orders. You place SL orders with a selling price and a trigger price. The worst-case pricing is fixed at Rs. 243, and the order is first activated for Rs. 244. 

The sell limit order is issued to the NSE when the price of Rs. 244 is triggered, which is the practical aspect. The square-off instruction that comes after will never be for less than Rs. 243. Thus, your danger is reduced.

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Conclusion

A stop-loss order is a straightforward technique that can provide essential benefits when utilized correctly.

Nearly all investing approaches can benefit from this technique to limit excessive losses or lock in profits. Consider a stop-loss as a type of insurance: Although you hope you never need it, it is comforting to know that you are covered in case you do.