October 18, 2009
The Importance of Stop Loss in Equity Trading
Equity trading refers to the process of buying and selling a company’s stock. This stock is divided into units known as shares. Shares of various companies are traded in the local and international stock exchanges of the world. Some of the major stock exchanges in the world are the New York Stock Exchange, the London Stock Exchange and the Tokyo Stock Exchange. In a sense these stock exchanges are similar to auction houses where the trade of these stocks and shares take place.
Equity trading can be done by the owner of the stock itself. They can also be conducted by agents like stock brokerage firms to carry out the buying and selling of the shares on behalf of the sellers and buyers.
An Order is the term used for the instruction placed by the customer to buy or sell shares in a stock market. These orders can be a simple buy/sell or it could be complicated with the same buy/sell order with conditions attached to it. Let’s look a little more closely at something called the Stop Loss Order.
Stop Loss Order on a particular share is based on its stop price. The order essentially is to buy or sell the stock once it reaches (or drops below) its specified stop price. Let’s say the stock in question being traded is of XYZ Corporation. The brokerage firm, on behalf of its client, has purchased 100 shares of XYZ at $80 which means the total value is $8000. Now we will look at two scenarios where a stop loss order will come into effect.
Scenario 1 – Let’s say the stock of XYZ is on an upward rise and the stock broker has been instructed by his client to sell it once the stock reaches $100 per share. The stock broker then puts out a stop order at $100 on the shares of XYZ. Once it reaches that price in the stock market, the stop order gets converted into a market order and the shares will be sold off at $100 leading to a sale value of $10000. This leads to a profit of $2000.
Scenario 2 – Let’s go with the above example and assume the client did not sell his stock at $100. He wants to see how much more the stock will rally before he decides to sell it. However he wishes to hedge his bets and issues a stop order to his broker at $90. This means that in the event of the stock price falling he will sell all his shares at a total value of $9000 thereby netting him at least $1000 in profit.
So simply speaking a stop order is a conditional order on a share which is bought or sold when a particular condition is met. The above were just two examples of the stop order. Stop Orders are a critical part of equity trading as they allow brokers to conduct large volumes or purchase and sale without constantly monitoring the ticker. It also allows buyers to be able to purchase a stock when it is at an affordable price to buy. It is also a good opportunity for sellers to book either higher profits or hedge their bets by booking lower or no losses.