Remember what happened when the news of irregular accounting in Satyam Computers hit the market or more recently when Ranbaxy’s drugs were banned by the USFDA. The stock prices in such scenarios correct at such extraordinary rates that nobody gets an opportunity to get out.
A stop loss order works as a safety mechanism which gives a trader the ability to restrict his losses in case of an unexpected movement in the price of a security.
To explain in the simplest way, a trader taking a position can specify that his position be squared off once his losses reach a certain level. Amongst other things, one area where this is particularly helpful is to insure against a sudden rise or decline in the price of an underlying security.
Stop loss orders are most useful for day and short term traders, particularly in the F&O markets. This is because traders typically attempt to buy and sell at smaller price movements. Moreover, if you want to take many positions at the same time, it is just not possible to follow them all at the same time and it is advisable to secure yourself by placing stop loss orders at the time of taking a position.
Having a pre-placed stop loss order ensures that you get a preference over market orders placed “AFTER YOUR STOP LOSS ORDER TRIGGERS”.
Trigger Price in Stop Loss Orders
One of the most important aspects of a stop loss order is that it tells the system to cut off your position at a certain price point. That said, how this works in practice is best explained with an example.
Example 1 – You buy 10 lots of Nifty @ 7,200 and deposit a margin amount of Rs. 2,90,000/- in your margin account. Remember a single lot of Nifty consists of 50 units. Now each single point movement in the Nifty will result in Rs. 500 profit or loss to you depending upon the direction of the movement. If the Nifty falls to 7,150 points, your (notional) loss would reach Rs. 25,000/ (i.e. 10 lots * 50 * 50). As a trader you must have some discipline in terms of the amount of loss you are willing to take on a single trade before you square off that position. In the above scenario, let’s say you conclude that once your margin amount of Rs. 2,90,000 reduces to Rs, 2,60,000 (i.e. a 30,000 rupee loss), you would like to exit this position. In such a scenario you can place a stop loss order to square of your 10 lots of Nifty @ 7,140.
A Distinction between Stop Loss (SL) and Stop Loss Market (SL-M) Orders
There are 2 prices at work in a stop loss order. First is the trigger price and the second is the limit or the execution price. Trigger price is the price at which a stop loss order gets activated. Execution price is the price at which you want to square off your position i.e., the price at which you want to exit. To explain with an example, consider the scenario below:
You sell 10 lots of Nifty @ 7200 and deposit a margin amount of Rs. 2,90,000 in your margin account. Remember a single lot of Nifty consists of 50 units. Now each single point movement in the Nifty will result in a Rs. 500 profit or loss to you depending upon the direction of the movement. If the Nifty falls to 7,150 points, your (notional) profit would be Rs. 25,000/ (i.e. 10 lots * 50 * 50). However, if the Nifty rises further and reaches 7,300 points, your (notional) loss would be Rs. 50,000. As a trader you must have some discipline in terms of the amount of loss you are willing to take on a single trade before you square off that position. In the above scenario, let’s say you conclude that once your margin amount of Rs. 2,90,000 reduces to Rs, 2,40,000 (i.e. a 50,000 Rs. Loss), you would like to exit this position. In such a scenario you can place a stop loss order to square of your 10 lots of Nifty @ 7,300 (i.e. 10 lots * 100 * 50).
Stop Loss (SL) and Stop Loss Market (SL-M) Orders
When you place a stop loss order to square of your position @ 7,300, TWO prices are to be kept in mind:
(i) Trigger Price – The price at which your order will be released to the exchange, i.e. this is the price at which your order will become active.
(ii) Execution Price – This is the price at which your order will be executed.
Why have 2 prices and what you must not do?
Having 2 prices is in line with a regular cash market order. Just like in cash market, here too you have the option of placing a market order and a limit order. Accordingly, until the market price reaches the trigger price, your order just sits with your broker.
Once the market price hits the trigger price, your order is released to the exchange:
- If you had placed a Stop Loss Market (SL-M) order, your order will be released to the exchange as a market order and will find a buyer/seller at any available price.
- If you had placed a Stop Loss Market (SL) order, your order will be released to the exchange as a limit order and will get executed only if it finds a buyer / seller at that limit price (i.e. after triggering it will become a regular limit order).
Something to keep in mind – The danger of using SL orders
Remember the concept of equilibrium and how share prices change. Many traders suffer a loss by wrongly placing an SL order and assuming it to be an SLM order. Look at the image on the left.
For this example, assume that you want to sell your lots once the price reaches Rs. 28.
Remember that when you place a SL order with a limit price (and not an SLM order), you run the risk that in case there is no buyer available at your limit price but is available below your specified price, your order will stay put while the price may decline to any extent. In the image example, assume that the price reaches Rs. 29 (i.e. trigger price) and your order @ Rs. 28 is released in the market. But after Rs. 28, the next available buyer is available at Rs. 27. You will sit there with a sell order @ Rs. 28.
Similarly in case you place a buy order with a SL at a certain trigger price, it is possible that your order does not execute for lack of buyer. To be safe always keep a bigger gap between the trigger price and the execution price.
In fact, if you were to look beyond the concept, I see little use for SL orders and always prefer to use an SLM order. The reason is simple, in case of a sudden movement beyond a point in the price of the underlying security, I would like to believe that this trade has gone bad, square it up at whatever price and get out of there.
Move on, there are always better opportunities in the market!