Stop-loss
 

Is the simplest, and one of the most widely used methods of hedging in the market. A stop-loss is an automatic trading order offered by all brokers. You can then set a price that the stock/instrument will automatically be sold at if that price is reached within the time period where the stop-loss order is active.

Let's take an example

 

Phil has 1000 shares in "Texa" which he has great belief that will rise further from fundamental assessments. Phil bought "Texa" at 114$ per. share, but wants to limit his risk and downside to a maximum loss of 10%. He thus calculates that the stop-loss order must be set at 103$. For the order to work the way Phil wants, he must:

 

Place a stop-loss order of 1000 shares with a deadline as far into the future as he wants. When entering a stop-loss, you must choose a trigger price and selling price.

Trigger price = the price where order is actually placed on the market and becomes visible in the order book. It should be set a bit above your desired selling price (max acceptable loss), as the price can fall at a pace where the trade does not go through if the trigger and selling price are too close to each other.

If you activate a stop-loss with a trigger price equal to 105$, the sales order will enter the market when the price reaches 105$, not before. It will only be put in the stock exchange system ready to be activated before this price is reached.

Sales price =  is the price you want to sell the share at (max acceptable loss), in this case, it will be at 103$.

 

By using a stop-loss, Phil will effectively secure his downside to 10% in his trade. If the share price rises further, you can always consider raising the stop-loss price, to secure your new gain. If you do not want to make a new trigger price and sales price if the stock rises, you can just leave the old order until the deadline expires. If you choose to sell the stock at a higher price manually without the stop-loss order having been activated previously, the stop-loss order will be automatically deleted when the order has expired.

It is important to know that a stop-loss is not 100% safe. There may be cases of excessive price fluctuations, which can lead to the stop-loss price being passed without being activated. There may also be technical errors, changes in the company's share capital, gap-opens, or the like, which may lead the stop-loss order to not get activated.

 

It is therefore always important to keep an eye if the price of an instrument you own is approaching a stop-loss level. If you only trade in stocks that are very liquid, this may prevent an instrument from falling so much and fast that the price goes past the stop-loss order without activating and executing it.

  stop-loss Perform a stop-loss hedge with a stop-loss