This Independence day, gift yourself freedom from unwanted loss in trading by learning stop-loss strategy

Most have made all the possible mistakes in the book and then some. But it is perseverance and discipline that made them successful.

Besides these, there is one magical word that every successful trader learns and imbibes in his trading plan without which he or she can never be successful. The word is stop loss.

These are the two most important words in a trader’s life.

As the word suggests it means stopping losses. Now in any business if losses are stopped or leaks are plugged chances are the business may turn profitable.

What is a stop loss?

In trading parlance, stop loss means the maximum loss a trader is willing to take on a particular trade.

Suppose a trader has Rs 5 lakh as his trading capital and wishes not to risk more than one percent on his trade, this would mean that on each trade that he takes he is going to incur a maximum loss of Rs. 5,000.

This would also mean that he would have to wrong 100 times in a row to lose his entire capital.

Execution problem

The problem with stop losses is they are easy to define but difficult to implement.

If a trader has bought a stock for 250 and has a stop loss of 240, unless he puts the stop loss order on the terminal it will be difficult for him to take the loss. When the price approaches 240, he will feel that the stock may rise soon.

If it goes below his level, he will feel that the loss is too much to take and will hold on to his stock till the price returns to 240, his original exit price.

Many retail traders go through this process. And if on a few occasions that they have placed the stop loss order, and the stock falls to their level, takes them out, and moves higher they will for a long time have aversion to stop losses.

Such events are part and parcel of the game. There will be days when the market takes you out and goes back to the original trend but more often than not market will crash through the stop losses and save you from a bigger loss.

Where to place a stop loss?

Many traders use an absolute stop loss, just like the one in the example above where the stop loss per trade is Rs 5,000. However, many professional traders prefer to place the stop loss at a point where the premise of taking the trade changes.

Suppose a price action trader would like to buy a stock around a support level. In such a case he would place his stop loss where the support level is clearly broken and his logic of buying at a point of low risk is defeated.

The trader may play around with the quantity so that the risk on the trade is less than one percent.

Let’s combine the two examples where an entry is made at Rs 250 and stop loss is at Rs 240 with a maximum loss of Rs 5,000 per trade.

Now the maximum loss is Rs 10 per share (250 – 240). So, in order to hit a maximum loss of Rs 5,000, the trader can take a position of 500 shares (5000 divided by 10).

Using it this way helps the trader manage his risk properly and at the same time enjoy the benefit of the trade on a larger quantity when it moves in his direction.

Trailing Stop Loss
Stop losses have another function apart from protecting losses. They also protect profits. Suppose if the price has shot up and of the point of entry and the trader fears of losing the profit but at the same time, he wants the trade to run.

Under such a condition he can move his initial stop loss to profit a large chunk of the move. If the market reverses, he may still take home some profit.

Conclusion

If there are two words that every trader needs to keep in front of his keyboard then it is Stop Loss.

Embracing it and living with it is the only way to move forward. Remember the first loss is the best loss, and that first loss has a name – stop loss.

(The author is Chairman, TradeSmart)

Disclaimer: Recommendations, suggestions, views, and opinions given by the experts are their own. These do not represent the views of Economic Times.