Public perception regarding capital markets in India has evolved drastically in the last three decades. From being limited to major financial centres like Mumbai and Ahmedabad, participation in capital markets has spread to smaller cities across the country. However, many people still lose substantial sums of money in the markets due to a lack of awareness. Trading without the knowledge of proper safeguarding strategies can lead to erosion of capital. A crucial tool to limit losses and preserve capital is to use stop-loss while trading in the share market.
What is stop-loss?
Stop-loss is a facility provided by most brokerages that is used primarily by short-term and intraday traders to curtail their losses or preserve their profits. It is an order that is placed to buy or sell a security once it reaches a pre-determined trigger price. For instance, you have the shares of XY priced at Rs 120 per share. You want to offload it for Rs 122 per share. But markets are a dynamic place and the share price can go beyond Rs 122, but can also fall below Rs 120. You can place an order with the sale price of Rs 122 and a stop loss of Rs 118. As soon as the share price goes below Rs 118, the brokerage will automatically cut your position without any intervention from you. Even though you will exit the position at a loss, the losses will be limited to Rs 2 per share. Setting a stop-loss limit is free of charge, but brokerages charge a commission once the trade is executed.
How does stop-loss help?
There are several benefits of a stop-loss order, especially for traders. Since traders and short-term investors profit from small price movements, stop loss helps in limiting the losses to a certain level. Stop loss helps curtail the role of emotions in the decision-making process. One can get carried away while buying or selling security and wait for the price to reach a certain level without focusing on the fair price. With stop-loss, traders determine their loss-absorbing ability and set the limit accordingly, eliminating the urge to stay put and wait for a bounce back.
Stop-loss orders are also a crucial tool in managing multiple open trades. Sometimes, it becomes difficult to monitor the movement of multiple securities at once, which can leave your holdings susceptible to excessive market volatility. Stop loss helps in managing the positions and closes certain positions automatically, saving you from excessive losses.
Can stop-loss preserve profits?
While the primary task of stop loss is to save a trader from excessive losses, a slightly different kind of stop-loss order can also be used to preserve profits. You can use a trailing stop loss to preserve the profits. A trailing stop loss starts as a regular stop-loss, but is not fixed and moves according to the movement of the share price. For example, you open a long trade in XY at Rs 100 and set a stop loss at Rs 95. You expect the price to touch Rs 110. When the price increases to Rs 105, the trailing stop loss changes to Rs 100. As soon as the price rises to Rs 110, the stop loss limit increases to Rs 105. But a trailing stop loss doesn’t change if the direction of the movement changes. If the share price falls to Rs 108, the stop loss remains unchanged at Rs 105. If the share price goes below Rs 105, the stop loss gets triggered and the position is closed, thus preserving a profit of Rs 5.
How to set stop-loss?
The stop-loss limit can be set taking into consideration different factors. A trader can set the limit according to his/her loss-absorbing ability or use historical support and resistance levels to determine a stop-loss limit. Stop loss on the basis of loss taking ability depends on the discretion of the trader, on the other hand, trendlines can be used to determine support and resistance levels. Stop loss should set below critical support levels as shares are observed to fall till a support level and bounce back after that.
Stop-loss has become a critical tool to avoid excessive losses and profit from minute movements in the market. It has become a central pillar of risk management. Tactfully using stop-loss orders can make your trading journey relatively safe from market movements.