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What Are Stop Loss Orders And How to Use Them

26 Jul 2023

What Are Stop-Loss Orders And How To Use Them?

Are you looking for ways to manage risks while trading in the stock markets? Then, you're not alone. No matter how experienced or skilled, every investor carries the risk of trade going sour and resulting in losses. Although, this is where stop-loss orders can help you. It can help investors protect their investments and limit potential losses. Therefore, read the article below to gain in-depth knowledge about stop-loss orders.

What Are Stop-Loss Orders?

A stop-loss order is a conditional order placed with a broker to sell a security at a predetermined price or percentage decline from the current market price. It is a protective mechanism that allows investors to mitigate losses by exiting a position when the price moves against their expectations. By setting a stop-loss order, traders establish an automatic trigger that executes a sell order if the security price falls below the specified level.

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Types Of Stop-Loss Orders

Stop-loss orders are further classified into the following types:

1. Fixed Stop-Loss Orders

Fixed stop-loss orders are those orders where the stop price is set at a predetermined level. Once the market price reaches or falls below the set stop price, the order is triggered, and the security is sold. This type of order provides a fixed level of protection against potential losses.

2. Trailing Stop-Loss Orders

Trailing stop-loss orders are those orders that automatically adjust the stop price as the market price of a security moves in a favourable direction. It "trails" the market price at a specified distance or percentage, allowing investors to lock in profits while protecting against potential downside risks.

How Does A Stop-Loss Order Work?

A stop-loss order works in the following step-by-step process:

Step 1: When a stop-loss order is placed, it remains inactive until the specified stop price is reached or surpassed. 

Step 2: Once the stop price is triggered, the order is converted into a market or limit order, depending on the type selected. 

Step 3: Then, the broker attempts to execute the order at the best available price. 

Advantages Of Stop-Loss Orders?

Stop-loss orders offer the following benefits to traders and investors.

1. Risk Management

Stop-loss orders provide a systematic way to manage risk by automatically limiting potential losses. They also help prevent emotional decision-making during market fluctuations and ensure that losses are contained within predetermined levels.

2. Protection from Unexpected Events

During periods of significant news announcements, prices can move rapidly and unexpectedly. Stop-loss orders act as a safety net, protecting investors from sudden price declines and minimising the impact of unforeseen events.

3. Time Management

By using stop-loss orders, traders can avoid constantly monitoring the markets. Once the order is placed, they can have peace of mind knowing that their positions are protected. This allows traders to focus on other aspects of their trading strategy.

4. Locking in Profits

Stop-loss orders are not only useful for limiting losses but can also be employed to protect profits. By adjusting the stop price upward as the security price rises, traders can ensure that a significant portion of their gains is preserved, even if the market declines.

Disadvantages Of Stop-Loss Orders?

Some of the drawbacks of stop-loss orders are:

1. Execution at Undesirable Prices

During price gaps, the execution of a stop-loss order may occur at a significantly different price than the stop price. This phenomenon is known as slippage, and it can result in more extensive losses than anticipated.

2. Triggering Premature Sales

Stop-loss orders may sometimes trigger premature sales, causing investors to exit positions too early. This can happen during short-term price fluctuations, resulting in missed profit opportunities if the market subsequently rebounds.

3. Increased Volatility Risk

Placing stop-loss orders too close to the current market price increases the likelihood of being stopped out due to minor price fluctuations. This can expose traders to unnecessary transaction costs and potentially impede long-term investment goals.

The Bottom Line

Therefore, understanding the types and workings of stop-loss orders is crucial for investors to decide when and how to use them. While using stop-loss orders, evaluating individual risk tolerance and market conditions is essential to determine the most appropriate use in any given situation.

 

Related Articles: Understanding order types and margining in commodities | The way you execute your orders can make a vast difference | Understanding the nuances of smart order routing

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