What is Stop-loss order

Legendary investor Warren Buffett says that you must follow two rules while investing:

the first rule is Never Lose your money, and
the second rule is Never forget rule number 1

This means that in investing and trading we will be able to survive for a long time only when we Save capital. And you can use a stop-loss order to save our capital.

So in today’s article, you will know what is a stop-loss order and how investors can minimize their risk by using it.

A stop-loss order is an order that after placing when the stock touches a certain price, the stock order will automatically sell. When the stock price touches this certain price, a market order is executed immediately and our stock is sold.

For example, suppose an investor buys a share at a price of Rs 25 per share, that investor does not want to lose more than ₹ 5 per share on this investment, then that investor can place a stop-loss order at Rs 20.

Now as soon as the stock price reaches Rs 20, that share will be sold automatically. When the prices fluctuate very rapidly, a stop-loss order can be very helpful for you.

So now we have learned what is stop-loss order and why to use it but whenever it comes to a stop-loss order, investors often confuse it with stop-limit order.

Although the purpose of these two orders is almost the same but there is a small difference between the two.

As we discussed earlier that in a stop-loss order, when the stock price hits the trigger price, a market order is executed at the same time and our stock is sold.

What is Stop-limit order

In contrast to a stop-limit order, when the stock price hits the trigger price, our sell order becomes a limit order instead of a market order.

Is there any difference between these two, yes the market order will be executed immediately whereas the limit order will be executed only when the stock price crosses that limit price.

Let us understand these two orders with this simple example when we placed a stop-loss order at Rs 20 and after that, if the stock price goes to ₹ 20 or below then our stock will be sold at the market price of that time.

Meaning that if the stock price goes from Rs.25 to Rs.21 and after that just directly becomes Rs.17, then our stock will be sold for Rs.17 also.

But this does not happen in the case of a stop-limit order. In the case of stop-limit order, whenever the stock price goes below Rs.20, our limit-order will be activated. If we have placed a stop-limit order, it ensures that the stock will not sell below Rs 20.

It will sell only at ₹ 20 or more, yes it may happen that after the stock price goes below ₹ 20, it does not touch back ₹ 20, then in this case the limit-order will not be executed.

So the difference between these two orders is that whenever the stock price goes below ₹ 20 or below, the stop-loss order will always be executed.

But it is not necessary that stop-limit orders should always be executed.

The main purpose of stop-limit orders is that sometimes the price of a stock falls far below the limit price and investors do not want to sell at that price.

Investors want that when the price increases and touches the limit price, only then their stock should be sold.

So stop-limit orders prove to be very useful in this case. So now we understand the difference between stop-loss and stop-limit orders.

Advantages of Stop-loss orders

The advantages of a stop-loss order are as follows:

The biggest advantage of stop-loss is that it reduces your risk and saves you from big losses in the stock market.

Another advantage of a stop-loss order is that it does not have any emotion attached to it. Many times investors get into emotions and start thinking that if the stock is given another chance, then our stock will come in profit.

But due to this delay, they have to face heavy losses later, so stop-loss saves you from this emotional attachment and helps you to take exit from the stock at the right time.

The third advantage of a stop-loss order is that a stop-loss order is not only used to minimize your loss, but you can also lock in your profit with the help of a stop-loss order.

Suppose you bought a stock at a price of Rs 100 and then its price becomes ₹ 150, you have such expectations that its price can go up further.

But at the same time, you want to lock the profit as well, in this case, you can place a stop-loss order at one ₹140. After this, even if the stock price goes down, you will still be able to earn a profit of Rs 40.

Another advantage of stop-loss orders is that you do not need to actively track your stocks after placing a stop-loss order.

So these were some of the benefits of stop-loss orders. Let us now understand some of the disadvantages of stop-loss orders.

Disadvantages of Stop-loss order

The biggest disadvantage of stop-loss is that due to a short-term fluctuation coming in the stock, your stop-loss order will be activated and your stock will be sold. So it is very important at which level you are setting your stop-loss.

For example, an active trader can set his stop-loss at the 5% level while for a long-term investor this level can be as high as 15% or even higher.

Another disadvantage of stop-loss is that because of stop-loss order, your stock can be sold at a lower price as we saw in the example that your stock can also be sold at ₹17.

So to avoid this, you can also use stop-limit orders, but there is a risk in stop-limit orders that sometimes your order does not execute.

So in this way you understood what is stop-loss order and how it is beneficial for investors. A stop-loss order can save you huge losses and you can exit the stock at the right time.

Apart from this, with its help, you can also lock your profit. Stop-loss orders are very useful not only for intraday traders but also for long-term investors.

Read Also: Types of Mutual Funds with Details

FAQ

What is stop-loss order?

What is Stop-limit order?

In contrast to a stop-limit order, when the stock price hits the trigger price, our sell order becomes a limit order instead of a market order. The market order will be executed immediately whereas the limit order will be executed only when the stock price crosses that limit price.

What is Advantages of Stop-loss orders?

The biggest advantage of stop-loss is that it reduces your risk and saves you from big losses in the stock market. Another advantage of a stop-loss order is that it does not have any emotion attached to it. Many times investors get into emotions and start thinking that if the stock is given another chance, then our stock will come in profit.

What is Disadvantages of Stop-loss order?