Imagine you’re out shopping and spot a cool pair of sunglasses priced at around Rs. 5000, which is slightly above your budget. You hope to buy it when the next sale goes live, and prices drop.
But what if that never happens? What if its price keeps rising on and on? Perhaps you’ll have to let go of that beautiful pair of sunglasses. Wouldn’t you wish there was some kind of a mechanism that buys the sunglasses for you before prices go out of hand, without you having to keep tracking the prices day in and out? But unfortunately, there isn’t any!
However, that’s not the scene in the stock market. In fact, you can actually buy your favourite company’s share at a predetermined price, as and when the share price touches it. The reverse works for selling as well. That’s the whole idea behind Trigger price.
Well, usually, trigger price comes in connection with Stop Loss orders. Hence, it’s imperative to first understand what Stop Loss orders are
Suppose you buy 10 shares of BOB ltd. at Rs. 80 each. You expect that the price will increase backed upon good quarterly results. But the market is very volatile. What if the price goes south? What if prices fall further and keep falling furthermore due to some unforeseen adverse event within the company?
Well, you’ll have to bear the brunt of selling it for some meagre sum. And when the trade is larger in scale, it could be devastating! But, luckily enough, there is a useful mechanism in the stock markets called Stop Loss orders.
Stop-loss orders are orders made in advance to sell an asset in case its price falls below a particular point. It, basically, helps you protect your downside while not having to monitor the stock exchange on a daily basis. It helps you limit your losses on a stock you’re previously long on and reduce your risk exposure. Like, quite literally, they stop losses.
Stop-loss orders are of two types:
- Stop-loss Market orders
- Stop-loss Limit orders
The following example will make it clear.
Stop-loss Market orders
Recall... you have 10 shares of BOB ltd. worth Rs. 80 each. You’ve no plans to sell them off at present. Although you’re confident about the investment, you don’t wanna take any risk. What if the price falls, unlike you’re expecting? You never know. However, considering your risk appetite, you can afford a maximum loss of upto Rs. 50 in the investment, and not more than that. So you do the following arrangement --
Notice that the current market price is Rs. 80. In order to hedge against (protect from) the downward movement of prices, you initiate a Stop-loss Market order. You mention the trigger price at Rs. 75. Now, once the upward trend reverses, i.e. prices start moving downwards (as against your expectations) and touch Rs. 75 (trigger price), your sell order will be active for execution. Meaning, your shares will be sold off at its market price prevailing at the moment the trigger is activated, most probably around Rs. 75. This way, your losses will be limited upto Rs. 50 [(80-75)*10], i.e. within your acceptable limits.
However, there is something that must be kept in mind. Although Stop-loss market orders protect your downside, they may not always do that entirely. For example: - continuing with the same example, a share of BOB ltd. was trading at around Rs. 80 at 1 p.m. today, when I placed the stop-loss order with the trigger at Rs. 75. By the time the trading day closed, the share price rose to Rs. 100. Overnight, there is some negative event in the company and the next day, as the trading day begins, BOB ltd.’s shares open at a price of Rs. 40! Mark that the opening price has already breached the trigger price (75), and hence, the shares will be sold off at the prevailing market price of Rs. 40! A straight blow of Rs. 400 [(80-40)*10]. Hence, I’ll have to bear the brunt far beyond my acceptable limits :( Bad luck, you know!
But wait, in NO way, it means that you’d avoid stop-loss orders. Why not use a Stop-loss Limit order instead?
Stop-loss Limit orders
So, basically, a Stop-loss Limit order is just a stop-loss order with a limit. Like you have the discretion to specify at/above what price you want your stock to be sold. For instance --
Here, I set my trigger price at Rs. 76 and the stop-loss price at Rs. 75 (and not the prevailing market price). Meaning, even if the price of the stock breaches my trigger price (76), the shares will be sold only at or above the specified stop-loss price (75). Hence, my loss will be limited to Rs. 50. Sorted, eh?
Simply put, the basic difference between stop-loss market orders and stop-loss limit orders is that in case the market price breaches the trigger price, the former guarantees you trade while the later guarantees you the price and NOT vice-versa.
Here’s a layman’s guide to setting stop-loss orders --
Stop-loss Market orders
Stop-loss Limit orders
Market price < Trigger price
Market price < Trigger price < Stop-loss Buy price
Market price > Trigger price
Market price > Trigger price > Stop-loss Sell price
To sum it up, trade triggers help you automate your entry and exit strategies. Needless to mention, stop loss is an important tool of short-term investment (exit) planning for small investors (usually, stop-loss orders are used in connection with sell orders, and we’ve done the same here).
Okay, recall, in the last example we dealt with, considering your risk appetite, we set the trigger and stop-loss at 76 and 75, respectively. That’s just one way of deciding where to set a stop loss. Here’re the various methods that’ll help you determine your stop-loss level.
Basically, there are three methods to determine where to set a stop loss –
a) Percentage method: This is completely at your disposal. Set your stop loss at a level, you are comfortable with. For instance, if you own a stock currently trading at Rs. 100 and you can afford to bear a loss of not more than 10%, then simply set your stop-loss sell price at Rs. 90. So, your maximum loss will be limited to Rs. 10 (i.e., 10% of Rs. 100).
b) Support method: Well, first, you need to identify support levels. We won’t over-complicate matters for you, just know this, that if you see the stock’s charts and you notice that in the (recent or distant) past, whenever the prices fell, they re-bounced from around a certain price level most of the time, then, that becomes the support level of that stock. So, set your stop loss just below the support level to allow the stock a little bit of wiggle room before you finally jump out.
c) Moving average method: Calculation of moving averages could be a tad bit complex in this limited space. So just know this, that it’s some kind of a dynamic method of calculating averages using a stock’s periodic changes in prices in the past. Just like the support method, in this method, also set your stop loss just below the long-term investment moving average of the stock.
*By the way, in each of the above three cases, the trigger price has to be set slightly above the stop-loss sell price (below the support or moving average, anyway).
The bottom line
You see, there are certain mechanisms in place in the stock markets to help you protect your downside and trade with safety. Stop-loss and triggers are the most important amongst them. They not only help you reduce your risk exposure but also give you the freedom to take a breath during trading hours without having to stick your eyes to the screen all day long. So, give your eyes some rest and put your brains into action.
Whether you’re an intraday trader or a long-term investor, you must use stop losses in your trades. You know it’s like going for an insurance plan against price downfall... you just wish prices never drop. And if it does, stop-loss has got your back.