What is stoploss and why is it necessary?

One must be well-aware of the two broad methodologies of making money in the market, either by investing in securities and holding them with the expectations of profiting from them in the long-term, or through intraday trading. Intraday trading, as it turns out, is filled with volatility. So, it becomes imperative for one to have some risk-management mechanisms to minimize the blows of the losses. In this article, we will talk about one such mechanism known as the stoploss and why it is necessary.

Let’s start-off by briefly going through the basics of intraday trading before we get to the concept of a stoploss.

Intraday basics

As the name suggests, intraday trading is all about buying and selling stocks on the same day. Unlike long-term investing, where one usually must stay invested for a comparatively longer time frame to realize profits, in intraday or day trading, one may generate profits within the same day, i.e., within the same trading session, if right decisions are made by the trader.  One major contrast between intraday trading and other forms of trading or investing is that delivery of stocks does not take place in intraday trading, as the concept revolves around squaring-off your position on the same day, irrespective of making profits or losses.

In India, one can day-trade several financial instruments, namely stocks, stock derivatives, commodity derivatives to name a few. Primarily, there are two mechanisms to earn money in intraday trading. One can buy a security at a lower price and sell it later at a higher price to make profits, or short sell the stocks, wherein a trader first sells it in the market and then buy it back later at lesser price, hoping that the price of this security declines.

Let’s now quickly go through the concept of leverage in day trading. Leveraged trading allows you to increasing the size of trade position, possibly to magnify returns. One aspect which is crucial to remember is that leveraged trading magnifies both profits and losses. The main objective of leveraging one’s trades is to open a position which will maximize one’s profits, with the underlying belief that the price of the security will move in their favour. However, if the price were to move against the investor, the losses would be much greater than they would’ve been had the position not been leveraged.

Concept of a stoploss

It must be clear by now that the premise of making profits through intraday trading involves trading those securities which are particularly volatile and fluctuate throughout the day. This is because trading those securities which aren’t so volatile would not fluctuate enough to generate chances of earning sufficient profits. As likely as it is to make profits, it is equally likely to make losses, and if not managed well, losses can mount substantially.

Here’s where the concept of a stoploss comes in, which is a risk-management mechanism. A stoploss is an automated risk-management instruction set by an individual with their respective broker to sell a specific security once the price of it drops below or moves up to a certain level, with the objective of capping one’s losses on a position. As an example, if someone buys a stock of a company for Rs.200 and wants to cap their losses to Rs. 10, then they can place a stoploss order at Rs. 190. So, if the stock price were to fall below Rs.190, the stoploss will be automatically triggered, and the stock will be sold at that price. The stoploss would limit the losses of this individual if the price would’ve fallen further below Rs.190, which wouldn’t have been the case had the stoploss not been set. Stoploss can be applied to short position as well where one can place the stoploss order at a price higher than selling price.

Stoploss orders are usually thought of as a way to prevent substantial losses, but they can also act as a tool to lock-in profits. A trailing stoploss order acts as a mechanism to protect capital gains while providing a hedge against any unexpected declines in prices. In this case, the stoploss order is dynamic and it changes as the price of the security fluctuates. As an example, assume that one sets a trailing stoploss order if the price of the stock falls below Rs. 10 of its market value. If the purchase price is Rs.100, the stoploss would be triggered once the price falls below Rs.90. On the other hand, if the price rises to Rs.120, then the trailing stoploss will stand at Rs. 110. So, in the event of the stock price falling after touching Rs.120, then the stoploss will be triggered once the price falls to Rs.110, allowing the position holder to realize a profit of Rs.10, as the purchase price was Rs.100.

This concept revolves around the fact that upon an increase in the stock price, an individual invested in it has an unrealized gain, which means that the individual doesn’t get the cash in hand until the stock is sold. A trailing stoploss order assists one in letting the profits run while also ensuring some profits are realized. Stoploss is not only relevant for intraday trade but also suitable for medium to long-duration trades to limit losses or secure profits.

Advantages of putting a stoploss

The first and the most important advantage is that it helps one in minimizing the losses on their trades, which may have been too large to recover from had the price tumbled down far too much.

Secondly, setting a stoploss on your trades helps in inculcating the discipline which is required in the markets by compelling one to stick to their investment strategy and maintaining one’s risk-reward outlook.

Disadvantages of using a stoploss

The first disadvantage comes up when a particularly volatile scrip fluctuates too much and ends up activating the stoploss and triggering a sale. This can be mitigated to a certain extent by choosing the stoploss such that day-to-day fluctuations can be accommodated for while preventing the downside risk as much as possible.

The second disadvantage is that traders need to analyse multiple external factors along with their own risk appetites while deciding a stoploss for a trade. It certainly is a tricky process which requires rigor.

Also Read: Five suggestions for intraday trading

Conclusion

To conclude, a stoploss order serves as a very effective tool in assisting one in limiting their losses while reducing the need for one to constantly keep an eye on their trades, particularly for those who wish to minimize their risk exposure while not missing out on generating profits.