- Date : 24/01/2020
- Read: 8 mins
A little-known risk management tool that can set your mind at rest while you holiday
Risks abound in the financial sector. The bank extends a loan to an individual or entity, the borrower defaults; the retail investor buys high-risk corporate bonds hoping for a windfall, the project fails; the fund manager invests in a tea exporter, currency fluctuations impact export revenues.
But for every eventuality, there are ways and tools to manage the risk. The bank checks for the borrower’s creditworthiness; the smart investor keeps a lid on greed and opts for low-risk government bonds, and the fund manager hedges his currency exposure with currency derivatives.
Risk management practices include strategies such as investment and portfolio diversification and financial tools such as options and futures. Stop-loss order is another way to safeguard investments; oft-overlooked, it is a handy strategy to cut losses early without having to keep track of the markets constantly. This is what will be discussed here.
As indicated by the name itself, a stop-loss order is an instruction to the broker to stop trade – on behalf of the investor – in case a stock price hits a certain pre-determined level. This is why it is sometimes also called a stop order.
It is an effective tool for investors to limit their losses on a position during unfavourable market conditions. The sale will probably be at the prevailing market rate, which may be lower than what the stop-loss order was set at. (For a better understanding, see examples in the next section).
Stop-loss orders are of two types: the sell-stop order and the buy-stop order, enabling the investor to limit losses both while selling and while buying.
A sell-stop order is entered at a price below the prevailing market price, while a buy-stop is placed above it.
Sell-stop order: This type of stop order is set at a particular selling price on the assumption that if the stock price plummets to the feared extent, it could very well dip further. With this order, the loss is capped at the optimum level for the investor.
A sell-stop order plays out if an investor places a stop-loss order on a long trade – buying in the belief that the stock price will go up – with the instruction for selling if the price reaches (falls to) a level lower than that at which the trade was opened at.
Buy-stop order: The principle is the same here like that for stop-buy orders. It comes into play when a stop-loss order on a short trade carries the instruction to buy when the prices reach (rises to) a level less favourable than where the trade is at.
It is advisable to note that the stop-loss order is simply a tool designed to limit an investor’s loss on a particular stock. It is not meant as a protection against sudden slippages that may occur because of unforeseen external influences, though it may get activated because of this. This is certainly a drawback, which will be discussed in a later pros and cons section.
Needless to say, there is no standard price level where stop-loss is recommended to be set. It is merely the number that the investor concerned is comfortable with.
However, when to activate the stop-loss option is always a tricky business, and will be discussed in a later section on how to determine its timing.
For a better understanding of how the stop-loss works, let us consider a fictional scenario involving a fictional company, Bihar Cement Ltd (BCL). Arun owns shares of BCL. He wants to offload his holding as the cement industry is going through a downturn, and he sees tough times ahead for BCL and its share price.
The BCL stock is currently reigning at Rs 50 per share, and sensing the uncertainty, Arun decides to offload if it falls to Rs 45. Accordingly, he tells his broker to enter a stop-loss order for Rs 45 per share on his behalf.
Please note that there is no guarantee that the share price fall will stop at Rs 45; if the price goes into a freefall to stop lower – say at Rs 40 – then Arun’s shares will be sold at Rs 40, which is the prevailing market price, regardless of his order to sell at Rs 45.
But what happens if the BCL stock were to rise, and not fall – will the stop-loss still be applicable? The answer is yes, and what is more, Arun can even make some “lock-in profits”, which refers to the realisation of unrealised gains using an option called the “trailing stop”.
(If stock prices go up, Arun will not see any real profits on his holdings unless he sells some of his stocks; this is called “unrealised gains”.
A “trailing stop” is a fixed stop price set at an amount below the market price with an attached “trailing” amount. As the market prices rise, the stop prices also rise by the “trailing amount”. If the stock prices fall, the fixed stop loss prices don't change. Basically, the price of the stop-loss adjusts as the stock price fluctuates. The market order – a buy or sell order to be executed immediately at the current market prices – is submitted when the stop price is hit.)
To understand how Arun can make some money, let us assume another scenario: instead of a downturn, the cement industry is set for an upturn following budgetary concessions to the sector. Market expectations for pushing the BCL stock are high, and Arun decides to sell so as to make some gains.
Accordingly, he sets the trailing stop order at 10% below the market price. As hoped for, BCL soars to Rs 60 over the next 30 days (it was Rs 50, to begin with), and Arun’s trailing-stop order locks in at Rs 54 (Rs 60 minus 10% of Rs 60 = Rs 60 minus Rs 6 = Rs 54). This means Arun will be in the black in this trade as Rs 54 is the worst price he would receive, which is still more than what the stock was worth before the budgetary concessions were announced – Rs 50.)
When to Activate
As stated earlier, investors often are in knots over when to set the stop-loss order; setting them too far away or too close can both lead to heavy losses. This is because the market can move the wrong way, or the sale can be made too early. However, there are three methods that the investor can adopt:
- Percentage method;
- Support method;
- Moving average method.
- Percentage Method: This is a popular method because it is simple. All one has to do is to determine the percentage of the stock price one is willing to give up before the exiting trade. This is the method Arun followed when the BCL stock went up – he was comfortable with the stock losing 10% of its value.
- Support Method: This is slightly more difficult to implement as the investor has to identify the stock’s latest support level – the price that a company’s stocks rarely go below. The stop-loss should be placed just below that level, so as to give the stock a little bit of wriggle room before the investor decides to exit.
- Moving Average Method: Here, the investor needs to apply a moving average – a technical analysis tool that creates a constantly updated average price over a specific period of time. The stop loss should be set just below the level of the moving average.
Pros and Cons
The stop-loss order is supposed to ensure that the loss being incurred from the plummeting stock price is capped at a manageable level. However, as the hypothetical scenario illustrates, an investor can be guaranteed at least some realised capital gain through the use of the trailing stop option. That is the first positive of stop-loss.
The second positive is that the stop-loss costs nothing; the requisite commission is charged only when the stop-loss price has been reached, and the stock is sold. In this respect, the stop-loss can be seen as a free insurance policy.
The third advantage is the leg-up that the stop-loss provides at a psychological level. It prevents the investor from getting “too attached” to a stock and thereby helps him/her to stay on track.
But the biggest advantage is that it spares the investor from the trouble of having to monitor stock performance on a daily basis; this means that anyone who has set the stop-loss order can take a break without having to worry about the fate of his investment.
On the flip side, a short-term fluctuation in the price of a stock can activate the stop-loss. As stated earlier, if the investor makes a mess of choosing the stop-loss percentage and not allowing intra-day or day-to-day fluctuations, the market order can be made at a level lower than desirable.
At the end of the day, you still have to make intelligent investment decisions if you want to make money on the stock market; the stop-loss orders do not guarantee that. If you are careless with your buy-sell calls, you will tot up losses even with stop-loss orders, just as you would without that precaution in place, albeit at a slower rate. Understanding the difference between investing in money markets vs capital markets will help you cut down market risks by a substantial amount.