Making stop-loss your safety alarm in the markets
The markets can be rather unforgiving sometimes.
During periods of volatility, the fluctuations can be so rapid that your buy or sell targets can come and go or your position turns from favourable to unfavourable in the blink of an eye. Setting stop-losses can alert you and preempt you from missing opportunities. There are a few things which stop-losses can and cannot do for you, as we explain in the blog.
But first, what is a stop-loss?
Like the name suggests, a stop-loss can be used to put a stop to potential losses that investors or traders face on a position in stocks by allowing them to specify a certain pre-defined price at which they may close their position.
So, let’s say you purchase a scrip at Rs. 100, hoping it will go up to Rs. 120. You do not want to make a loss of more than Rs. 5 in this trade. You can set a stop-loss at Rs. 95. On the other hand, if you sell a scrip at Rs. 100, expecting it will go down to Rs. 80 but are not willing to book a loss of more than Rs. 5, you can set a stop-loss at Rs. 105.
How can you place a stop-loss?
With an electronic trading system, you could feed the details directly onto the trading system, anytime.
To place a stop-loss on an electronic trading system, you need to have three details:
1) The current market price.
2) Limit price.
3) Trigger price.
Why not just specify the stop-loss? Why do we need a ‘limit price’ and ‘trigger price’?
Now here’s a little technical detail that you should know – stop-loss orders are saved in the exchange’s server in a special order-book (stop-loss order book). They are only submitted when the market reaches your specified trigger price. Once triggered, a stop-loss order becomes a normal order and gets traded. So, effectively, when a trade takes place at your trigger price or the market price crosses your trigger price, then exchange system transfers your order from special order-book (which is not live in the trading market) to the live market order-book, to get it executed.
In the meanwhile, before they get triggered, you can change the prices and/or quantities of your stop-loss order as many times as you like. In fact, you can cancel a stop-loss order too.
Coming back to the need for three rates, in electronic format, you have to tell the system at what rate the stop-loss order should be activated/submitted in the live market; and for it to get traded, a limit rate must be placed. This limit rate should be different (preferably) from the trigger price.
To illustrate using our earlier example, if you have entered a position at Rs 100 and set a sell stop-loss order at Rs 95.00, you may specify a trigger price of Rs. 96.00 and limit price at Rs. 95.00. The current price must be above 96.00, otherwise, the trading platform may reject the stop-loss order or it may get triggered immediately.
Typically, for a buy stop-loss order, the current price should be less than the trigger price, which in turn should be less than the limit price. In the case of a sell stop-loss order, the current price should be more than trigger price, which should be more than the limit price.
It seems like a perfect plan to ‘stop losses’ till here. But is it foolproof?
Unfortunately, no. In our experience, we have seen situations, although not very frequently, in which a stop-loss order does not deliver the desired results.
You may set a stop-loss order, which does not finally get traded, despite following all the steps perfectly. When your order is triggered and the exchange system submits it into the live market, it’s possible that at that fraction of a second too many orders to sell are placed or there are not enough buyers and, as a result, your order does not get executed; sometimes it could get partly executed and the rest could remain pending.
A stop-loss order assures you that your order will be placed at the desired moment, i.e., when the price reaches/crosses a particular rate but does not assure you that the trade will take place.
The simplest way to ensure that the chance of such a situation occurring is minimized is to ensure that you maintain a sufficient gap/difference between the trigger price and a limit price. The optimal difference will change from stock to stock, based on factors like the liquidity or volume in of that stock in the market or the impact cost. It will also depend on the quantity of the stock, which comprise your order.
In a rare case, during times of wild fluctuations, the price of your stock may reach the trigger price (of a sell stop-loss) that you have set and the sell order will get moved from the special order-book to the live market order-book. At the same time, buying comes in and the trade closes at a price that is higher than the trigger price.
During such times, investors/traders tend to mistrust the trading platform as they have not fully understood what has happened.
There are some other interesting aspects to stop-loss orders
1. Using trailing stop-losses to optimize your position
Let’s say you have purchased a stock at Rs 100 and placed a stop-loss at Rs 95 with a trigger of Rs 96.00.
Now, suppose the price moves up to Rs 115, but your target is Rs 120. But having seen the stock climb to such levels, the thought of the stop loss getting triggered at Rs 95 seems very disappointing.
So, you could move the stop-loss up to Rs 110, with a trigger of Rs 110 and a limit of Rs 105.
This method of adjusting the stop-loss to secure the downside is called setting a trailing stop-loss.
2. Setting a stop-loss order without a position
Sound strange? But think again; a stop-loss is just a name for a particular order tool, where trigger and limit rates are set. So, it can be used to simply place an order on your behalf when the market reaches a particular level so that you don’t have to wait in front of your screen for fear of missing an opportunity to enter a position at a specific price.
Let’s say, for instance, you want to take a position in a stock when it crosses the resistance of Rs 100. Right now, the current price is around Rs 97. You can put a buy stop-loss order with a trigger price of Rs 100.05 and a limit of Rs 102. Once a trade takes place above Rs 100, the stop-loss order gets triggered and it will be placed in the live market from the special order book.
We, Ventura Securities Ltd, (SEBI Registration Number INH000001634) its Analysts & Associates with regard to blog article hereby solemnly declare & disclose that:
We do not have any financial interest of any nature in the company. We do not individually or collectively hold 1% or more of the securities of the company. We do not have any other material conflict of interest in the company. We do not act as a market maker in securities of the company. We do not have any directorships or other material relationships with the company. We do not have any personal interests in the securities of the company. We do not have any past significant relationships with the company such as Investment Banking or other advisory assignments or intermediary relationships. We are not responsible for the risk associated with the investment/disinvestment decision made on the basis of this blog article.