What is Stop-Loss Order (Stop Order)?

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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.

Examples

Example #1

Let’s assume you own a hundred Apple shares, and you bought the share at $100 per share. The share is expected to reach $120 in the next month, but you do not want to risk 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 a market order and placed.

It is not necessary that the order will be placed at $90; it can also happen that it will be placed either at $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 equals $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 were 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.

Advantages

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 when the investor is on a vacation or any action that prevents him from checking on the stocks for an extended period.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 he/she is going to take if they incur losses. This is important for money managementMoney ManagementMoney management refers to the proper use of money, which includes creating a budget, understanding cash expenses and incomes, tracking the money spent, saving some income for investment and future use, eliminating unnecessary expenses, and keeping track of all items to understand cash spending and generation.read more. 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.read more. 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 eradicate the financial bias and let the investors trade on investment goals rather than an emotional attachment.

Disadvantages

  • 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 times of market crash. They have contributed to the 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.read more in 2008. Stop loss was triggered as the prices began to fall in October 2008. This flooded the market with sell orders, which made the prices decline further. When 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, examples, advantages, and disadvantages. You can learn more about financing from the following articles –

  • Loss Given Default CalculationMarket Order vs Limit OrderShare Trading AccountBuy Limit OrderProfit Taking