A Stop Loss order is a damage limitation strategy. The order pre-determines the price at which a financial instrument will be disposed off, to prevent any further losses from continued reduction in the price of the instrument.
Stop Loss in Action
Let us assume that you purchase shares of a company for Rs.100/- each, planning to dispose off the shares when the price per share touches Rs.120/ But instead, the price begins to decline. To contain your losses, you instruct your broker to sell your shareholdings once the price per share touches Rs.95/-. Thereby, you stop your loss at Rs.5/- per share.
Analysis
If the share price rises, you can gain from the upside. If the share price declines, you will suffer only a limited loss which is the maximum that you are prepared to incur. Once the stop-loss order is communicated, you do not have to constantly monitor the share for limiting your loss. But this strategy is generally relevant only for investors engaged in speculation for short term profits. For long term investors, the stop-loss mechanism carries the risk of booking losses at an early stage instead of allowing the investment to mature and gain in valuation. Often, a decline in price may signal a buying opportunity.
Lovely article !!!! Stop loss seems like amazing structure , which actually limits the loss.The highest risk in equity markets is risk of principal amount loss.This situation can be easily observed in case of Bearish markets.When the trader fails to predict the downtrend , the stock starts rallying downwards without any intimation.In such cases , stop loss plays as support as it limits the risk , adjusted as per individual risk appetite.