Stop loss is a method of ensuring that you limit your losses if a stock falls. An example of how Stop Loss works and where its benefits as well as limitations lie.
A position with a Stop Loss is activated in the event of the price falls below a certain level. Stop Loss can be seen as a way to prevent major losses. A stop Loss is set when the price of the share has fallen 10% below the purchase price, and is therefore sold as soon as possible. When I mean as soon as possible, it must be with the understanding that there must be a buyer for the position you intend to sell. The buyer may well be lucky enough to buy your position at a lower price than you have specified as Stop Loss. This must be explained by the fact that the limit of Stop Loss tries to get rid of your position as soon as possible and has no effect on which price is traded.
Example 1:
The stock was bought at price 50 and is currently trading at 60. The stop loss limit has been specified to be 45. If the stock price falls at or below 45, an immediate sale order will be placed. The sale order does not have a limit on the price, so your stock could potentially be sold at a price lower than your stop loss – this is very important. There is no guarantee it will be sold at price 45. The sale order might go through at price 42 or lower. The higher the liquidity the better your chances of getting a decent price for your stock.
Example 2:
The stop loss level to use should depend on your risk profile and also take into account the volatility in stock price. For example, if the price go up or down by 2% either direction on a normal trading day and the stop loss is only there to avoid severe losses. In this case you may want to have a stop loss level that is 2-3 times the daily volativity. This is only example and your risk profile may require a different approach to calculating the optimal stop loss level.
Advantage
If you do not have the opportunity to keep an eye on your investments during the day, you may risk a major capital loss after which you have not had the opportunity to sell out.
Disadvantages
Great way to prevent large losses, but it’s just as good at preventing people from falling sharply after full of a twice as large increase which ultimately means that your stock actually ends up being a solid plus at closing time. (Just an example of how unlucky one can be when using SL).
In the event of black Monday sale or a critical event that causes panic reaction in stock prices, the market could see significant drops in prices, potentially well below your stop loss. Some times the market recovers very quickly thereafter but you may risk losing out because your stop loss was triggered during market panic.
Even if you have Stop Loss at your position, you are not sure that your position will be sold in the event of a price drop. Even if the price drop has triggered Stop Loss, you can risk that there are no buyers in the market, and while the price continues downwards, the value fades out of position, buyers can suddenly arise. The problem is that in the beginning the price had fallen by 10%, but that buyers have only arisen when the price has fallen by 30%, which is the price that will most likely be traded at. You can thus achieve a greater loss than assumed.