- A stop-loss order refers to an order placed with a broker to buy or sell a security when it reaches a certain price.
- Investors place a stop-loss order when they expect stock prices to move against their expectations.
- However, investors may face challenges while deciding where to set stop-loss order level.
Stop-loss is a widely used term in the stock market, which refers to an order placed with a broker to buy or sell a security when it reaches a certain price. Investors place a stop-loss order when they expect stock prices to move against their expectations.
To put it simply, if you purchase a stock at AU$30 and place a stop-loss order at AU$19.50, the stop-loss order will be executed when the stock price hits AU$19.50. It would safeguard you against further loss.
However, investors may face challenges while deciding where to set stop-loss order level. While setting them up too far would result in big losses in case of market making opposite moves, setting up too close can get one out of a position too fast.
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What should investors consider while setting up a stop-loss order?
The stop-loss order should be derived in such a strategic way that it limits losses. A stop-loss order placed at AU$24 for a stock purchased at AU$30 limits downside capture to 20% of the original position. It is known as the percentage method.
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It is important to know where to place a stop-loss before you start trading in a particular security. There are several other theories on stop-loss placement as well.
There are theories that are based on universal placement which means executing 6% trailing stops on all securities. A few other employ securities or pattern-specific placements such as average true range percentage stops.
Another common method is support method, which involves hard stops at a fixed price. This method requires experience since investors needs to find out the stock’s most recent support level. Once figured out, the stop-loss order can be placed just below that level.
Moving average is another common method. In this method, investors place the stop-loss order just below a longer-term moving average price.
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Swing traders are also known to use a multiple-day high or low method. It includes placing stops at the low price of a pre-determined day's trading.
The other critical factor to consider while setting stop-loss level is volatility. Volatility can be analysed to place a stop-loss outside the normal fluctuations. It can be done by measuring the typical price movements on a particular day. Thereafter, investors can set stop-losses and profit targets based on the observations.
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Key things to consider with stop-loss orders:
- Stop-loss orders play no role in active trading.
- Stop-loss orders don’t work in case of large blocks of shares.
- Investors must keep an eye on brokerage fees since they charge different amount for different orders.
- Investors should never assume that the stop-loss order has been executed and instead, wait for the order confirmation to be sure.
What should investors consider?
Investors should be clear about their risk appetite before going for a stop-loss. There are securities for which retracements are common. These require more active stop-loss orders. Even as stop-loss is about risk management, it may not guarantee profits for investors. Thus, before moving ahead with stop-loss, investors must completely understand the pros and cons of the risk management tool.
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