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Knowledge Corner

Trading Techniques-Concept of Stop Loss

STOP LOSS
Introduction
A stop loss is an order to buy (or sell) a security once the price of the security climbed above (or dropped below) a specified stop price. When the specified stop price is reached, the stop order is entered as a market order (no limit) or a limit order (fixed or pre-determined price). With a stop order, the trader does not have to actively monitor how a stock is performing. However because the order is triggered automatically when the stop price is reached, the stop price could be activated by a short-term fluctuation in a security's price. Once the stop price is reached, the stop order becomes a market order or a limit order. In a fast-moving volatile market, the price at which the trade is executed may be much different from the stop price in the case of a market order. Alternatively in the case of a limit order the trade may or may not get executed at all. This happens when there are no buyers or sellers available at the limit price.
How does stop - loss order work, and what price is used to trigger the order?
A stop-loss order, or stop order, is a type of advanced trade order that can be placed with most fund houses. The order specifies that an investor wants to execute a trade for a given stock, but only if a specified price level is reached during trading. This differs from a conventional market order, in which the investor simply specifies that he or she wishes to trade a given number of shares of a stock at the current market-clearing price. Thus, a stop-loss order is essentially an automatic trade order given by an investor to his or her brokerage. It will only become active and be executed once the price of the stock in question falls to the specified stop price stated in the investor's stop-loss order.
For example, let's say you are long 100 shares of XYZ Corporation. You bought the shares at Rs. 20, and now they are trading at Rs.30 per share. You want to continue holding the stock so you can participate in any future price appreciation it may see. However, you also don't want to lose all of the unrealized gains you have built up so far with the stock, and you would want to sell out of your position if XYZ shares fell to Rs. 25.
For most stop-loss orders, normally looks at the prevailing market bid price (i.e. the highest price for which investors are willing to buy the stock at a given point in time), and if the bid price reaches the specified stop-loss price, the order is executed and the shares are sold. The bid price is used for stop-loss sell orders - instead of the ask price or the market clearing price - because the bid price is the price a seller can receive presently in the market. In our example, a stop-loss order placed for 100 shares of XYZ at Rs. 25 would effectively limit your potential losses, ensuring you are able to sell your shares for Rs. 25 should your stock head south.
Types of Stop loss order
Stop Loss Limit Order
A stop loss limit order is an order to buy a security at no more (or sell at no less) than a specified limit price. This gives the trader some control over the price at which the trade is executed, but may prevent the order from being executed.
A stop loss buy limit order can only be executed by the exchange at the limit price or lower. For example, if a trader is short and wants to protect his short position but doesn't want to pay more than Rs.100 for the stock, the investor can place a stop loss buy limit order to buy the stock at any price up to Rs.100. By entering a limit order rather than a market order, the investor will not be caught buying the stock at Rs.110 if the price rises sharply. Alternatively a stop loss sell limit order can only be executed at the limit price or higher.
Advantages and disadvantages of the stop loss limit order
The main advantage of a stop loss limit order is that the trader has total control over the price at which the order is executed. The main disadvantage of the stop loss limit order is that in a fast moving volatile market your stop loss order may not get executed if there are no buyers/sellers at the limit price.
Stop Loss Market Order
A stop loss market order is an order to buy (or sell) a security once the price of the security climbed above (or dropped below) a specified stop price. When the specified stop price is reached, the stop order is entered as a market order (no limit). In other words a stop loss market order is an order to buy or sell a security at the current market price prevailing at the time the stop order is triggered. This type of stop loss order gives the trader no control over the price at which the trade will be executed. A sell stop market order is a order to sell at the best available price after the price goes below the stop price. A sell stop price is always below the current market price.
For example, if a trader holds a stock currently valued at Rs.100 and is worried that the value may drop, he/she can place a sell stop order at Rs.90. If the share price drops to Rs.90, the exchange will sell the order at the next available price. This can limit the trader’s losses (if the stop price is at or below the purchase price) or lock in some of the profits.
A buy stop market order is typically used to limit a loss (or to protect an existing profit) on a short sale. A buy stop price is always above the current market price. For example, if an trader sells a stock short hoping the stock price goes down in order to book profits at a lower price, the trader may use a buy stop order to protect himself against losses if the price goes too high.
Advantages and disadvantages of the stop loss market order
The main advantage of a stop loss market order is that the stop loss order will always get executed. The main disadvantage of the stop loss market is that the trader has no control over the price at which the transaction is executed.
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