Finance

Why Stop Loss is Important in Option Trading?

Stop-loss can be a valuable tool and a double-edged sword for your investment portfolio. On one hand, it frees you up from having to monitor your stock holdings every day. But on the other hand, short-term price changes can activate the stop as well, triggering a sale you don’t want. Should you incorporate a stop-loss into your investment strategy toolkit, or stick with regular option trade alerts? The choice is up to you.

What is a Stop-Loss Order?

A stop-loss order is an agreement with your broker to buy or sell specific security when it reaches a given price. The purpose of a stop-loss is to limit your risk of loss on a security if the price ever starts to tank. When used at the right time and in tandem with other smart portfolio management practices, it can make a world of difference and benefit just about any investor. 

Advantages of a Stop-Loss Order

  • You’re freed up from having to monitor your stock holdings daily.
  • They don’t cost anything to implement – your broker’s regular commission is only charged when the stop-loss price has been reached and the stock is sold, so it’s a bit like a free insurance policy.
  • It’s an easy way to lock in profits.
  • It helps you make an emotion-free decision. People can get attached to certain stocks or hold onto them for too long, hoping they’ll turn around. Stop-loss orders eliminate that emotion-based human error.

Disadvantages of a Stop-Loss Order

  • A short-term price fluctuation could activate the stop, triggering an unnecessary sale. To avoid this, pick a stop-loss percentage that allows for day-to-day price fluctuation. Aim to only trigger a stop-loss if the stock takes a steep nosedive or is on a consistent, notable downward trend.
  • You need to be a confident investor who knows your boundaries. There’s no right or wrong choice when it comes to stop-losses – whether it’s a 5% or a 15% drop, the right decision is whenever you’re comfortable calling it. Because of this, it might not be a great option for investors who struggle to make their own decisions.
  • It’s not a perfect option. When you hit your stop price, it becomes a market order. This means the price you sell at might vary from the stop price, impacting your return on your investment.
  • You can’t place stop-loss orders on every security. Some brokers won’t let you put them on certain securities, especially penny stocks or OTC Bulletin Board stocks.

Who are Stop-Loss Orders Best and Worst For?

Stop-loss orders probably won’t benefit you if you’re the type of investor who likes to buy stocks and hold them forever. They also don’t guarantee your success in the stock market. You still have to make sound investing decisions. A stop-loss won’t save you from an investment that was bad in the first place.

But for a lot of people, stop-losses are the best of both worlds. Used correctly, they can especially be helpful for beginners. New traders have a lot to keep track of, which can be overwhelming. Because of this, new traders tend to forget about risk management. Stop-losses add in fail-safes to help new traders stay on top of their level of risk.

All in all, stop-loss orders aren’t for every investor, nor are they for every investment portfolio. But in the right hands, they’re a great asset. However, they won’t replace your regular option trade alerts.

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