If you are concerned about losing capital on an ASX share, you may choose to set a stop-loss order to sell your shares if the price falls to a certain amount. This limits your potential losses.
Let's take a closer look at the pros and cons of using this investment tool.
What is a stop-loss order?
Investors typically use stop-loss orders to limit losses on share positions.
A stop-loss is an order to buy or sell a specific share at a certain price, which is known as the 'trigger price'.
If you are concerned about losing capital on an ASX share, you may choose to set a stop-loss order to sell your shares if the price falls to a certain amount. This limits your potential losses.
For example, suppose you bought Commonwealth Bank of Australia (ASX: CBA) at $80 a share, and you want to limit your potential losses to 20%. You would then set a stop-loss order for $64. If the CBA share price falls below $64, your shares will be automatically sold. This limits your loss to 20% of your initial capital.
When do investors use stop-loss orders?
Stop-loss orders are used to manage risk — they can be thought of as a sort of insurance policy. You can also use stop-loss orders to help you stay on track with your investment strategy.
It can be easy to become attached to the ASX shares you own. This can give rise to the sometimes false belief that the price of a particular ASX share will rise over time. This belief can cause delays in exiting positions, in turn causing losses to mount. Stop-loss orders can prevent this from occurring and remove emotion from the process.
Although traditionally used to limit losses, you can also use stop-loss orders to lock in profits. In this scenario, stop-loss orders are sometimes referred to as a 'trailing stop'. Under a trailing stop, you can set the trigger price at a percentage level below the current market price, which adjusts as the share price moves. This allows profits to run while also guaranteeing the realisation of at least some capital gains if the share price falls.
When the price of an ASX share moves beyond the trigger price of a stop-loss order, it immediately becomes a market order to buy or sell at the best available price. This means that in a rapidly-moving market, a stop-loss order may not be filled at the exact trigger price but fairly close to it.
Stop-loss order versus stop-limit order
A stop-limit order combines the features of a stop-loss order with those of a limit order (an order to buy or sell a specified number of ASX shares at a given price). Under a stop-limit order, two price points are set:
- The stop price — the start of the price range for the trade
- The limit price — the outside of the price target for the trade.
Once the stop price is reached, the stop-limit order becomes a limit order to buy or sell at the limit price or better. Of course, there is no guarantee a stop-limit order will be executed. This will only occur if the stop price is reached during the period of the order.
A stop-loss order becomes effective once the stop price is reached. It is then executed at the current market price. A stop-limit order, on the other hand, is executed only when the trade can be performed at the limit price or better. The benefit of a stop-limit order is it gives precise control over when the order should be filled.
How do you place a stop-loss order?
You can place a stop-loss order via your broker. When placing an order, you need to carefully consider the trigger price. It should ideally allow for some fluctuation in the share price but serve to remove you from your position if the price turns against you. Placing a stop-loss order is a strategic choice that should reflect your investment strategy.
When starting out, it is recommended that you use a simple stop-loss strategy that allows the price to move in your favour but cuts your losses if the market moves against you.
Pros and cons of stop-loss orders
Stop-loss orders can be used to reduce risk exposure, limiting the amount of capital at risk in the event of an adverse market movement. They can be especially helpful in the event of a sudden and significant price movement against your investment position.
Nonetheless, because a stop-loss order becomes effective when the trigger price is reached, it is then executed at the prevailing market price, so it may provide only limited protection in extreme circumstances.
