Importance of Stop Loss in Trading

Did you know that you can stop trading ‘automatically’ once your stock value drops to a certain point? Discipline is as necessary for trade as it is in academics. The act of trading involves using capital judiciously and keeping track of how and where you are spending. Therefore, you must discipline yourself before becoming a trader to avoid any disruptive investments.

As an investor, you always function on a given amount of funds. These finite funds determine your risk appetite and risk-bearing capacity. Stop loss in trading is a concept that asks you to ‘STOP’ investing after you lose a certain amount of funds.

For instance, imagine that you have Rs.500 as investmen funds and you can lose only up to Rs.50. In this case, you put a stop loss at Rs.450. Once the value of market shares reaches Rs.450, the stocks owned by you will automatically be sold.

When it comes to stop-loss, there are a few terms that beginners might get confused between. In the world of trading, we must understand two terms related to stop loss: stop loss order and stop limit order. Many people believe that they are the same concepts, even when they have different uses in a stock market.

Understanding Stop Loss In Depth

A stop loss order is triggered when the value of the stock falls below the trigger price. Imagine that for a Rs.50 investment, you have a trigger price of Rs.45. Now, a market order to sell the stock will be triggered for any value of Rs.45 or under that the stock drops to. In other words, no matter what the price the stocks were bought for, the stocks will be sold at the market price when the value goes below the trigger price.

Also read: Difference Between Risk Appetite, Risk Capital and Risk Tolerance

In the case of a stop limit loss, the stop loss will be triggered. However, the stocks will only be sold when the market value of the stocks goes back to the trigger price, or higher than that. Continuing from the previous example, if the market price falls below Rs.45, say Rs.30, your stocks will not be sold because of a ‘limit order’.

The market order to sell will only be initiated if the stock price goes back up to Rs.45 or above. Therefore, a ‘limit order’ makes certain that your stocks are not sold for a value lower than your trigger value. In cases where the value of the stock doesn’t go back to the trigger value, a limit order will not be executed.

What are the advantages of a stop loss in trading?

  • It prevents you from losing your money when the market falls dramatically. For a stock that is on a periodic decline, the stop loss will sell your stock as soon as it touches the trigger price. This way, you will not have to face big losses and can save some of the money that you had once invested.
  • If you ever gain profits on the money you invested, you can put new stop losses at the profited price. For example, if you earn Rs.50 on an investment of Rs.50, you are now in possession of Rs.100. So the former stop loss of Rs.45, can be increased to, say, Rs.80. This way, even if the stocks fall at a later stage, you can still have some profit under your name.
  • Stop loss in trading doesn’t consider your psychological musings. Most often investors will start thinking about how the loss in the stocks is temporary and it will soon go back to its original value. Because of this belief, they lose a lot of money. However, because of stop loss being automated, it immediately sells your stocks with no strings attached. It helps you move from one bad stock to a better investment opportunity.
  • As already mentioned, stop loss is automated. Therefore, you will not have to keep checking the fluctuating prices, to see when your money drops below the amount you are comfortable losing. This gives you mental peace and prevents you from fretting about changing stock prices.

What are the disadvantages of stop loss in trading?

  • We saw how, sometimes, the stock prices can fall far below your trigger price. If your trigger price is Rs.45, and the stock price drops to Rs.20, the market order will immediately be initiated and the stocks will be sold at that price. This way, you can lose a lot of that invested money.
  • Your stocks will be sold even if the drop in the stock prices is for a short period of time. If the prices drop to Rs.40 against a trigger price of Rs.45, for two days, before going back up to Rs.50, your stocks will still be sold immediately.
  • In situations like these, you can use the stop limit order. However, there is no guarantee that the stock price will definitely go back up to your trigger price. So the order to sell your stocks might never be initiated.

When it comes to stop loss, you need to figure out how much money you are comfortable losing. Beginners often set up a lower percentage of loss appetite, and long-time investors often go for higher numbers. Stop loss can be a curse to lose all your money, or a blessing if you can plan your losses right.

Disclaimer: This article is for information purposes only. The views expressed in this article are personal and do not necessarily constitute the views of and/or the author shall not be responsible for any direct/indirect loss or liability incurred by the reader for taking any financial decisions based on the contents and information. Please consult your financial advisor before making any financial decision.