Overview of Stop Loss Orders
A stop loss order, as the name may suggest, is a finance strategy that literally helps you the investor stop any further losses on your investment. It is basically an instruction to your broker to automatically sell a given investment in a share should the share price fall below a set price.
Sometimes referred to as the stop order, the main aim of this strategy is to protect you the investor from abrupt falls in share prices. It allows you to take control of your investment by controlling the amount of possible loss that you can make on the given shares if the price falls down.
How to protect your investments in the stock market
When investing in the stock market, you should know that you will not make any profits unless you sell your shares for more than you used to purchase. One big challenge for most investors is to know when to sell their shares and how to protect their investment.
While you may not want to sell too early so as to miss on additional profits, you also don’t want to hold on to your stocks for too long The stock market being as volatile and as dynamic at it always is, it is very easy for one to have their entire investment wiped out very fast if they do not take the necessary steps to cushion themselves against falling prices.
It is often much difficult to know when to sell than to know the right price to purchase. But, if you need to make money out of your shares (which is basically the ultimate goal for all traders), then you must have a strategy that will protect your profits. The use of stop-loss orders is the easiest exit strategy for most investors. It is the easiest way to increase one’s odds of continued existence when trading futures and commodities.
As previously mentioned, they are a of futures order type that you place to limit your losses on given futures trade. One thing that should be mentioned is that without an exit strategy on futures deals, it is very easy to watch your profits literally slip off your fingers as you wait for a down trending stock to bounce back. For instance, you purchase a stock for $30 per share.
The company you have invested in takes a good run and the prices escalate to $35 per share. Will the prices continue to go up or will profit takers pounce in and sell the shares, which will ultimately drive the prices down? This is a fact you do not know for sure. In order to protect your stock, you enter a stop-loss order for $25 a share meaning if the stock starts to plummet in price, you can hold on to see if the prices will bounce back.
However, the order will come into effect when the prices go beyond $25 per share. At such a point in time, your order will be a market order hence the stock will be sold at the existing market price. What this means is that you would have protected a profit of $5 a share, while leaving some room for fluctuation below $30 a share. When everything remains constant, you will get so close to the $25 a share stop-loss price.
This is typically a conservative strategy that will protect some part of your profits. Most brokers today will allow you to enter a stop loss order that will help track up the price. One point of caution is that stop-loss orders are only effective in normal markets. What this means is that if the market drops or crashes dramatically and suddenly, then the price may keep plummeting through the stop-loss and keep going down very fast.
The Main Benefits of placing Stop Loss Orders
Any trading strategy should cover the amount that you are willing to risk on any particular trade. The perfect way to employ your strategy is to place an order on each position immediately your stop loss is implemented. This will ensure you are disciplined in managing and taking control of your risk and helping you stick to your strategy. The most attractive thing about a stop loss is the fact that once placed, you forget about second guessing yourself of getting out of a bad trade.
One typical mistake made by most traders is sitting down and watching an awful trade turn into a worse and disastrous one. How demoralizing can it get to look at the screen and see your preset loss of $500 turn into $2500 in days? This is very possible and has happened to very many losing traders who have not taken the initiative to use a stop loss.
Types of stop-loss orders
Stop loss orders are mostly used as exit trades and will always limit the amount of loss. However, some traders will use them as the only exit strategy, while others will use them as a backup exit strategy. There are therefore two types of stop loss orders:-
Normal/ Regular Exit strategy
When a trader wants to use a stop loss as the only exit strategy, it is kept as close to the current price as possible, at the maximum loss the trader is willing to go for on a normal trade.
Backup Exit strategy
This strategy is also referred to as a crash stop loss order, or an emergency order, and is often kept far away from the current market price, such that it is only used as the last resort i.e. when no other exit strategy can be filled.
Important Points to keep in mind about stop loss orders
You should be very careful when it comes to where you set the points. In other words, if a stock generally fluctuates between 3 and 5 points, you should be wise enough not to set your limit too close to that range because it will mean the stock will be sold under normal price fluctuation, which you definitely do not want.
A stop loss will not guarantee you against losses. Be advised that when disaster strikes, it may plummet so fast the best you can hope for is to get out at least close to your predetermined price
A stop loss will take the emotion out of a selling decision by defining a floor on the lowest side.
A stop loss is ideal if you are planning to be away from the stock market for some time, say while on vacation. Setting your stop loss order will ensure you have some protection against unforeseen disaster.
A Stop loss order is your greatest insurance that costs you nothing, but can save you a lot.