Question

You own 200 shares of Shamrock Enterprises that you bought at $25 a share. The stock is now selling for $45 a share.
a. You put in a stop loss order at $40. Discuss your reasoning for this action.
b. If the stock eventually declines in price to $30 a share, what would be your rate of return with and without the stop loss order?

Answer 1

200 shares bought at $25 per share.

Current selling price is $45 per share.

a) Stop loss order is at $40 : It is an order placed by the investor where he states the price at which he is willing to buy or sell. He also states the value below which he would not be willing to execute the transaction. This value below which the investor would not be willing to execute the transaction is known as the stop loss order.

When the stop loss order is placed at $40 then it implies that we are willing to sell the shares of the Company at $40 and not less than that. The shares were purchased at $25 per share but they are currently selling in the market at $45 per share. The intention of doing this is that in case the share price falls below $45 then we will be willing to sell the shares if the share price falls till $40 and not less than that.

The aim of a stop loss order is to avoid losses. By purchasing at $25 per share and selling at $40 we will earn profits.

Cost of purchasing the shares is:

Amount earned from sale of shares at $40:

Profit if the shares are sold at $40 is:

Thus, we want to earn minimum $3,000 from the transaction and not less than that.

b) Rate of return when Stock price declines to $30 :

If the stock price declines to $30 and there is no stop loss order then the calculations will be as follows:

Cost of purchasing the shares is:

Amount earned from sale of shares at $30:

Profit if the shares are sold at $30 is:

Rate of return is:

If the stock price declines to $30 and there is a stop loss order then the calculations will be as follows:

The price at which the stop loss order is set is essential. If the stop loss order is set at $30 then:

Cost of purchasing the shares is:

Amount earned from sale of shares at stop loss order of $30:

Profit if the shares are sold at $30 is:

Rate of return is:

If the stop loss order is set at any value higher than $30 then it will not be executed as the value of the shares in the market is less than that value. So, the order would not be executed. The rate of return would then be 0%.