WHILE THIS IS A GOOD FORM OF RISK MITIGATION HAVING ITS MANY ADVANTAGES, IT ALSO HAS A COUPLE OF DISADVANTAGES THE INVESTOR NEEDS TO BE WARY OF.
Stop-loss order is wonderful risk mitigation tool that an investor can use to protect his or her portfolio. An investor who wants to limit his or her losses can activate a stop-loss order to cut investment losses from a drastic reduction in share price.
The investor simply informs his or her broker beforehand of the price rate or percentage that the stock price must drop to in order to initiate a sale. As such, where losses seem to be increasing as a result of a continuous downward trend in stock prices, an investor can choose a price that he or she cannot afford to go beyond.
When it hits the stipulated price, the broker then sells. While this is a good form of risk mitigation having its many advantages, it also has a couple of disadvantages the investor needs to be wary of.
Advantages of Stop-Loss Orders
It Is A Risk Mitigation Tool: Much like insurance, a stop-loss order is solely in place to limit the amount of losses you can make on an investment. This affords the investor a level of comfort or peace of mind where there is high price volatility.
It Is Cheap To Implement: Unlike many other risk mitigation strategies or hedging strategies that would cost something to implement, this order is as simple as putting a call across to your broker.
It costs absolutely nothing to implement. Regarding the commission, commission is charged when the stop-loss price has been reached and the stock needs to be sold.
Little Demand for Monitoring: A very common advantage is that the investor does not have to monitor stock performance on a daily basis. Monitoring your investment portfolio is a great idea; however, research shows that monitoring it makes you spend so much money.
It also keeps you constantly worried about the state of your shares which can force you to make a panic exit from the market. With a stop loss order in place, you can even travel out and relax without having to check your stock performance unduly.
Disadvantages of Stop-Loss Orders
Short-term fluctuation could be mistaken for a stop-price: This is probably one of the toughest challenges with the stop-loss order. Where there is high market volatility for a certain, the stop-loss order might be activated only for it to rise again.
At the end of the day, you might realize that you lost more than you gained from selling your shares abruptly.
No fixed rate or rules on where to fix the rate: In order to both prevent losses while also being careful not to have it dissuaded by mere temporary price movements, the investor would need to set a price that gives that balance.
Unfortunately, that is left solely to the discretion of the investor. There are no rules or basis to form guidance.
The Stop-Loss Price Might Not Be The Price The Shares Are Sold At: Prices in the stock market can change in seconds. As such, when a stop price is reached, it is possible that the locked-in price and the price that the shares would be sold for might differ.
This is because the moment the investor reaches his or her preferred stop price, the stop order becomes a market order and the price that it would be sold at might now be even lower than the stopped price.
In other words, an investor who wants to use stop –order as a risk mitigation tool needs to consider both sides of the table before choosing whether to make the jump or not.