Question

Arianna just made a fantastic investment: She purchased 400 shares in Great Gains Corporation for $21.50 per share. Yesterday the stock closed at $56.50 per share. In order to lock in her gains, she has decided to employ a stop-loss order. Assuming she sets the order at $56, what is likely to happen? Why might this not be a wise decision? At what price would you recommend setting the stop-loss order? Why?

Kindly explain with figures. And I will appreciate it if you type all three answers and explain with detail. This is Personal Finance Course

Answer 1

Stop loss order is basically a special type of trading order which is used to prevent losses in the portfolio. Stop loss orders sells the shares when the price falls to the extent & hits the set price of Stop-Loss order , known as the trigger price .

Part I

When she sets a Stop Loss order at $56 , it is basically the trigger price of the Stop loss order . As soon as the live trading price will hit the $56 level , the sell order will be activated and will sell off the entire holdings at the specified rate preventing further losses in the portfolio.

The trading system will accept the stop loss order at $56 and the order will be kept in pending until the price hits 56 level . If the price dosent fall to that level, nothing will happen , if it falls the holdings and shares will be sold off

Part II

This is not a wise decision because of the following reasons :

• the stock has provided high returns from 21.50 to 56.50.
• The stock seems to be in a bullish mode and further price rise is being expected .
• The Stock must be highly volatile with a high beta .

hence highly volatile stocks prices fluctuate a lot in intraday , and it may be possible that for a small moment the price will fall to 56 hitting the Stop loss and will rise again. hence she would not be able to acquire those additional gains .

Part III

I would recommend setting the stop loss at around $48.025

Reason

The calculations are ased on the VaR or the Value at Risk for the stock .

The apprecialtion is price is 56.50/21.50 = 2.62 times .

We can expect the stock to have a Beta index of return to be 2.62

So VaR Standardized = 5.62*Beta based on the underlying index volatility

or VaR= +- 5.62*2.60 = +/- 15%

So the Range of Stop loss would be - Last Trade price - 15%

= 56.50 -15% = 56.50* (1-0.15) = $48.025

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