How do stop-loss orders work?

Stop-loss orders are essential tools for managing risk in the stock market. They automatically sell your securities when they fall to a certain price, allowing you to limit your losses without having to monitor the market constantly. Understanding how stop-loss orders work and when to use them can help you maintain better control over your investments and prevent significant financial setbacks. In this blog, we’ll dive deep into the mechanics of stop-loss orders and how you can use them effectively.

1. What is a Stop-Loss Order?

A stop-loss order is a type of order placed with a broker to buy or sell a security when it reaches a certain price. It's designed to limit an investor's loss on a position in a security. For example, if you buy a stock at ₹100 and set a stop-loss order at ₹90, the stock will be automatically sold if its price drops to ₹90, thus limiting your potential loss to ₹10 per share.

Stop-loss orders are used by investors to protect themselves from large losses in case the market moves unfavorably. They’re particularly useful in volatile markets where prices can change rapidly.

2. How Does a Stop-Loss Order Work?

When you place a stop-loss order, you set a predetermined price at which the broker will automatically sell the security. The main purpose of a stop-loss order is to prevent losses from escalating too far by setting a floor price for the stock. Here’s a simple breakdown of how it works:

• Placing the Order: You enter a stop-loss order with your broker, specifying the price at which the security should be sold. For example, if you own a stock priced at ₹200, and you set a stop-loss at ₹180, the stock will be sold automatically if its price drops to ₹180.
• Activation: The stop-loss order remains inactive until the stock hits or falls below the specified price. Once that price is reached, the order is triggered, and the broker will attempt to sell the stock at the next available market price.
• Execution: After activation, the order becomes a market order, meaning it will be sold at the best available price. However, there’s no guarantee that it will sell exactly at the stop-loss price, especially in fast-moving or illiquid markets.

3. Types of Stop-Loss Orders

There are different types of stop-loss orders that cater to various investment strategies. Here are the main types:

• Standard Stop-Loss Order: This is the most basic form of a stop-loss order, as described earlier. The order triggers a market sell order once the price hits the stop price.
• Trailing Stop-Loss Order: A trailing stop-loss order is dynamic. Instead of setting a fixed stop-loss price, it moves along with the stock's price. For example, if the stock price rises, the stop-loss price rises along with it, but it does not move downward. This allows you to lock in profits while still protecting against downside risk.
• Stop-Limit Order: This order combines a stop-loss and a limit order. Once the stop price is hit, the stop-limit order triggers, but it will only sell the stock at a certain price or better. This prevents the stock from being sold at a price much lower than the stop price in a fast-moving market.

4. When to Use a Stop-Loss Order?

Stop-loss orders are typically used when you want to protect your gains or limit your losses. However, there are a few scenarios where they can be particularly helpful:

• In Volatile Markets: Stop-loss orders are essential during periods of market volatility, where prices can swing drastically in a short amount of time. They ensure that you don’t incur significant losses if the market moves against you.
• During Earnings Reports: If a company’s earnings report is expected to affect its stock price, a stop-loss order can help protect you from potential negative impacts if the stock price drops suddenly.
• In Long-Term Investments: If you hold long-term positions and don’t have the time to monitor the market regularly, a stop-loss order can help ensure that you don’t lose more than you’re willing to risk.

5. Advantages and Disadvantages of Stop-Loss Orders

Like any trading tool, stop-loss orders come with both benefits and drawbacks. Here’s a breakdown:

• Advantages:
  • Automatic Risk Management: Stop-loss orders provide automatic risk management, reducing the need for constant monitoring.
  • Emotional Control: They help investors avoid making emotional decisions, particularly during market downturns.
  • Protecting Gains: Stop-loss orders can lock in profits by preventing large losses from eroding your gains.
• Disadvantages:
  • Execution Price May Vary: In volatile markets, your stop-loss may not be executed at the exact price you set, leading to a greater loss than expected.
  • False Triggers: A stop-loss order can be triggered by short-term price fluctuations, causing you to sell prematurely.