What is stop-loss and how to set your stop-loss?

Blog | Trading 101

New to trading? Stop-loss is a term that you will hear often. 

But what is a stop-loss? And why is it important? Let’s understand.

What is a stop-loss?
As the name suggests, stop-loss is a trade order placed to limit your losses. A stop-loss can either be a buy order or a sell order but is the opposite of your open trade. For instance, if you have gone long on (bought shares of) Reliance at ₹2,000, the stop-loss is placed at a level below the purchase price, say ₹1,950 or ₹1,900. And if you have gone short (sold), say Nifty Futures at 18,000, the stop-loss is placed above your selling price, could be 18,100.

What happens when you place a stop-loss?
Reverting to the example of Reliance, imagine you have invested ₹1 lakh on the trade. You’ll be able to buy about 50 shares at ₹2,000. You have a view that the stock will climb to ₹2,100. If the trade goes right, you will end up making ₹5,000 profit (₹100 per share * 50 shares). In case the trade doesn’t go as expected, you’d want to limit your loss to, say, ₹5,000. In order to do this, after or while entering a purchase order for Reliance, you can also place a stop-loss order at ₹1,600. Thus, if Reliance shares fall instead of rising, your stop-loss order will get triggered. This system will send a ‘sell’ order if and when Reliance drops to ₹1,900. This will lead to squaring off (closing) the open position at ₹1,900, thereby limiting your loss to just ₹5,000.

When and where to set stop-loss?
The key to a successful trading strategy is where one places a stop-loss. There are various factors that determine your stop-loss. The first could be a basic principle of limiting losses. In the example mentioned above, the stop-loss is determined by your ability to absorb losses. However, this may not be the right way to go about things. If your loss-absorption capacity is high, you might unnecessarily end up losing a lot of money on the trade. And if it is low, your stop-loss may be very close to your purchase/sell price, triggering an unnecessary trade.

A more sophisticated strategy would be to use technical analysis to determine the stop-loss. There are various tools and indicators one can use to find the support and resistance zones and strategically place stop-loss orders. These tools can be accessed even through your mobile trading application. For a long position, the stop-loss is ideally placed near or slightly below the support zone. This is because, if a stock or an index breaks its key support level, there is a risk that it can fall even more sharply. A stop-loss, therefore, helps exit the position early. On the flip side, for short positions, the stop-loss is usually placed near or slightly above the resistance zone. 

Types of stop-loss
There are mainly two types of stop-loss orders. In market parlance, they are called SL and SL-M orders. An SL (Stop-Loss) order is where the exit price is fixed by the trader. Here, as discussed earlier, shares of Reliance will be sold at ₹1,900 only. So the trigger price and sell-order price are the same for SL orders. On the other hand, under an SL-M (Stop Loss-Market) order, the trader only sets the trigger price, the actual order can get executed at that price or anywhere below. So, the above example, for an SL order the stop-loss and the execution price would be equal to ₹1,900, while for a SL-M order, the stop-loss is equal to or less than ₹1,900. Under SL-M, the order gets executed at the next available market price. SL-M orders come in handy in cases where there is low liquidity in the stock or when the price falls drastically. For example, if for an SL order at ₹1,900, there aren’t enough bids, a portion of the sell order may remain unexecuted. For SL-M orders, the entire sell-order gets executed at ₹95 or the best price available below the trigger price.

Disadvantages of stop-loss
There are certain short-comings or situations where stop-loss orders may not prove to be that efficient. For one, a stop-loss may not work for large traders. Stocks or derivatives contracts that are highly liquid, a stop-loss can get executed without any hassle. But for large orders or scrips with low trading volumes, the stop-loss orders may not get executed fully, resulting in wider losses or confusion. Similarly, when the stock witnesses wild short-term fluctuations, we see that a stock or even the index momentarily drops and reverts to its earlier position. Such events can unnecessarily trigger stop-losses and there is nothing one can do about it as the trading system is pre-programmed to execute orders you have placed. Another disadvantage of a stop-loss order is that the stock may not follow a particular trading pattern. For instance, assume you entered Reliance at ₹2,000 with a stop-loss of ₹1,900 and price target of ₹2,100. After your buy order, the stock goes to ₹1,890 before climbing to ₹2,100. In such cases, your position will get squared off and you won’t benefit from the ensuing rally.

One has to remember that a stop-loss is a prudent strategy to mitigate risk. Many see it as an insurance policy. It may not always result in a profitable trade but may help cushion your fall.

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