Stop Loss: Meaning, Types, Factors To Consider

Stock markets are unpredictable and thus are often associated with risks. When you combine their inherent nature with the human psyche and emotional decision-making, you have the perfect loss-making strategy in place! Fear and greed are emotions that have a notable impact on investment decisions. They are also the primary reasons behind all the advisory to base investment decisions on research and not emotions.

Effective risk management is the key to navigating market uncertainty, minimising losses, and making profits. It is, thus, quintessential to apply effective and time-tested risk management strategies. One of the most powerful risk management tools is ‘stop-loss.’ Think of it as a safety net that can shield you from potential losses if markets take an unexpected turn. 

Now, let’s dive deeper into understanding what stop-loss is, how it functions, and its importance in modern markets.

Understanding Stop-Loss

In real-time, market movements are so swift and unpredictable that despite having the best strategies, you may miss important signals and register losses if you do not exit at the right time. A stop-loss instruction tackles just this. 

Stop-loss, as the name suggests, is a risk management tool that helps to limit loss. It is a widely used tool in the stock market. You can consider it a direction from the trader to the broker, following which a share is automatically sold in case the price dips below a certain level. Focus on the word ‘automatically’ here. 

The stop-loss instruction that traders set gets automatically triggered (in case of a price fall beyond a pre-specified figure) and requires no manual intervention from the trader. Consequently, you minimise your exposure to risk and limit your losses without having to follow the markets like a hawk.

In market terms, a stop-loss order can be considered a buy/sell order that traders may place when they are concerned that price dips may cause them significant losses. It is, however, important to remember that a stop-loss can reduce your losses but not eliminate them. 

Let’s take a quick example to understand how stop-loss works. Imagine you have recently purchased 10 shares of a banking giant – XYZ, at ₹100. The stock is showing positive movement; however, you know that markets can swing anytime and want to protect yourself against losses.  So, you place a stop-loss order at ₹80. 

Now, say the share starts falling and is about to break below ₹80. Your stop-loss will get triggered at ₹80, and shares will be sold automatically. Imagine a situation where stock XYZ extends its downturn, falling to ₹70, ₹60, or even ₹50. Your current loss (at a stop-loss of ₹80) is ₹200 (₹20*10). But without a stop-loss, it could be ₹300 or ₹400 or more. 

You see, one cannot predict how low a stock may run. But by placing a stop-loss, one can exit their positions before incurring significant losses. 

Types of Stop-Loss Orders

• Fixed Stop-Loss

This is the most straightforward type, where the stop-loss price is set at a fixed price. So if a stock is trading at ₹120 and your stop-loss is set at ₹100, then the stop-loss will be executed (and shares will be sold) when the share hits ₹100 (just like the example above). 

This type of stop-loss provides a clear and predetermined exit point. Below are the other types of stop-loss orders that fall under this type. 

• SL (Stop-Loss Limit)

A Stop-Loss Limit (SL) order is set with two price points: the trigger price, which activates the order, and the limit price, which is the minimum price at which you're willing to sell. For example, if you set a Sell SL order with a trigger at ₹98 and a limit at ₹97.85, the order is activated if the stock price drops to ₹98. But, it only executes when the price is ₹97.85 or higher, not below. This ensures you don't sell for less than ₹97.85, but if the price drops too fast below ₹97.85, the order might not execute at all.

For a Buy SL order, the order is activated when the market price reaches or exceeds the trigger price, which is lower than the specified limit price. In this scenario, if the trigger price is set at ₹110 and the limit price at ₹110.20, the buy order is activated at ₹110. The order will then be executed at the best available price up to ₹110.20, ensuring you do not pay more than this limit. The execution could occur at prices such as ₹110.15 or ₹110, but it will not exceed the limit of ₹110.20. This setup aims to control the maximum price paid while ensuring the order is executed within a specified price range once the trigger is met.

• SL-M (Stop-Loss Market)

In SL-M, the emphasis is on trigger price. Say an SL-M order is executed with a trigger price of ₹110 for a buy order and ₹90 for a sell order. Now, when the trigger price of ₹110 is touched, a market order is sent to the exchange, resulting in the acquisition of the position at the prevailing price. Similarly, if the stock touches ₹95, a sell market order is sent, and the position is squared off. 

2. Trailing Stop-Loss

A trailing stop-loss is a flexible risk management tool that automatically adjusts with the stock price's upward movement, maintaining a set percentage or price distance below the peak price achieved. 

For instance, with a stock initially at ₹50 and a 10% trailing stop-loss, the stop level is initially ₹45. If the stock price climbs to ₹55, the trailing stop-loss escalates proportionally to ₹49.5, securing gains while providing downside protection. This mechanism ensures the trade stays advantageous for the trader by automatically locking in profits and limiting losses if the stock's price reverses.

Now that you understand the different types of stop losses, it is important to remember that they must be adjusted periodically based on changing market conditions and investment goals. 

Factors To Consider for Setting Stop-Loss

Below are the factors you must consider before deciding to set a stop-loss instruction:

• Individual Risk Tolerance 

No two investors can have similar risk appetites, and this uniqueness is the primary factor to consider when setting a stop-loss. 

Let’s assume two individuals – Mr X and Mr Y and a stock named ABC trading at ₹100. Both Mr X and Y want to invest in the stock ABC. Mr X is comfortable with 15% volatility in stock ABC, i.e., the stock price does not dip below ₹85. Mr Y, on the other hand, is comfortable with a volatility of only 10%, i.e., the stock price does not dive below ₹90. For the same reason, on the same stock, Mr X will place his Stop-loss at ₹85 while Mr Y will place his Stop-loss at ₹90. 

Thus, conservative investors may opt for a tighter stop-loss, while an aggressive investor may choose a wider stop-loss. 

• Volatility

Volatility (along with other market conditions) is a critical factor to consider when considering a stop-loss. It can be viewed as the degree of swing or price fluctuations a stock can experience during a certain time frame. High-volatility stocks tend to experience larger price swings, which may require traders to consider wider stop-loss levels (to avoid being triggered prematurely).  Conversely, if trading in less volatile stocks, traders may require a tighter stop-loss for protection against unexpected declines.  

• Time Frame

The investment time frame is another factor one must consider when setting a stop-loss. Short-term investors may opt for tighter stop-loss levels since their horizon is limited, and they aim to capture quick gains. 

Long-term investors, on the other hand, may choose wider stop-loss levels to allow for larger price movements. 

• Fundamental and Technical Factors

Traders must watch out for all company and industry-related news, such as financial health, growth prospects, competition, negative news, and more, as they may directly impact stock prices. They should also be concerned about how the economy is moving and what fiscal policies are being formulated.

Also, there is no alternative to technical analysis. Various indicators and tools may come in handy for traders looking to set a stop-loss.

Why Is It Important To Set a Stop-Loss?

Stop-loss is your first step in risk management, and its importance in real-life markets cannot be overstated. 

By strategically placing a stop-loss order, investors establish predefined exit points, safeguarding them against inherently volatile and unpredictable market fluctuations. Imagine a point in trade when you have a prefixed stop-loss in place. You then are no longer worried about the continuous market swings. You know your money is protected, and you are exiting before booking enormous losses. 

You must also appreciate that the stop-loss order, besides reducing losses, functions as an automation tool, too. This feature gives investors the luxury of not having to monitor their portfolio 24/7, ensuring a swift response to fluctuations without any manual involvement or constant vigilance. 

Also, you may agree that maintaining a sound balance between risk and reward is a challenge when trading. Since different individuals have varying risk appetites, stop-loss orders ensure that the trader’s predetermined risk-reward strategy remains intact. 

Emotions may also play a significant role in trading, often influencing decisions in both rising and falling markets. The joy experienced during market highs can quickly turn to panic during downturns, impacting trading strategies and risk tolerance. This emotional rollercoaster can disrupt even the most thought-out plans. Using a stop-loss strategy introduces discipline, helping traders stick to their initial plans without being swayed by emotional reactions to market fluctuations. It acts as a safeguard, ensuring decisions are based on pre-set parameters rather than the heat of the moment. 

Lastly, stop-loss orders can help instil a sense of control in an otherwise fast-moving market. Investors have a physiological assurance that their risk exposure is capped regardless of external market conditions. 

And with this, we come to the end of the chapter on stop-loss. In the next chapter, we shall explore trending indicators, their types and much more.