Stop Loss Theory

Stop Loss Theory

When we take a trading position or a delivery position, we always take it with an expectation of profit, which is obvious thing. But for some reason, if circumstances change, and our decision go wrong, we must have the ability to exit from such positions in time. And stop loss is a key factor that helps us do this.

Most of the time people initiate a trading position, short or long, and after taking the position, they decide a stop loss. But very few people act on what they decide. When market crashes suddenly due to a panic, at that time they face decision paralysis. In such cases they watch helpless, and prices of their holdings plunge sharply in front of their eyes and they are not able to do anything and they incur big loses.

There are primarily two type of Stop Losses that you can take into consideration

o   Primary Stop Loss: Which is a level below your Initial Buy Price

o   Trailing Stop Loss: Which is a level above your Initial Buy Price

But first let us understand,

Why people fail to employ Stop Loss in their Investments and Trading Strategies

Most of the people know that they must follow strict stop loss, but very few follow this rule. Then the question arises that why does they do that? Some times what happens that in cases of sudden panics, the prices fall sharply, and they rebound equally sharply, and so during the sharp decline, a stop loss is triggered, and later on the same stock rises back to the old levels, and people feel that they made a mistake. But what we need to understand that such instances of prices rising back again sharply after a stop loss being hit are very few, say 2 out of 10 times. So two times you could get trapped in a whipsaw, but the other 8 times, you are saved.

People need to understand their own thinking. Mostly once a position is taken and it starts declining more than expected, most traders hope that the prices will pull back a little, and then they will exit. But in most cases prices fail to pull back to the extent they expect, and prices keep on declining, and fear of the trader rises too. In such panic circumstances, most people lose their decision making power. That is why before we are faces with such circumstances, we must follow the stop loss and exit the position in time. No one goes bankrupt by doing stop loss in time. But cases of people loosing their entire savings and property due to failed stop losses are sadly innumerable.

Benefits of Stop Loss

Following stop loss upon trigger is like applying brakes to your car at right time. We very well know that what will happen if we fail to apply breaks of our car at right time.

Stop loss works like a parachute. When we plunge from heights, we have to open our parachute in time to safely come to the ground. If we wait more than a certain level, it becomes fatal. Same is with stop loss, if we do it in time, it saves us from further erosion which could be lethal for us.

Consequences of Not Applying Stop Loss and Trailing Stop

Holding a declining stock without a stop loss is like riding a boat that is sinking. One has to jump from the boat at right time with the help of a ring or a lifeboat, so that we do not drown with the boat. Stop loss is our lifeboat, or safety ring.

When one fail to employ stop loss, their capital gets eroded before their eyes and they are not able to do anything.

When one fail to employ Trailing stop, profits on capital get eroded, and we get back to square one.

What to do: First apply Commonsense

Innumerable real life examples like this can be given. In real life people follow the safety rules, but I don’t know what happens to their common sense when it comes to stock market.

Big speculators are aware about this weakness of most of the traders and investors, so they take advantage of it. Who is to be blamed for this?

We wander into the wild with open chest, without any protection, skills and tools, and if we get butchered then we are responsible for our fate, and no one else.

Market always gives at least one opportunity to everyone to save themselves and exit at right time. Seldom does market crashes without signals in advance. But as people do not know how to take advantage of the signals, they fail to take timely actions.

So instead of blaming others, we acquire the required skills and tackle such forces to our favor. As mentioned before even in case of a fight, one must first acquire necessary skills to use the weapons, and have required armors with them if they want to survive and more importantly succeed.

If we try to fight in the battlefield with open chest, and no weapons at hand, what would be the result? Even a small child can answer this correctly.

Courage is not the only element in stock market that will make us victorious. What is more required is a clever mind and proper strategy at hand.

Many people do not follow stop loss; thinking that it is a sign of weakness, and they think that by holding a loosing position like that is a brave thing to do. But this proves to be a foolish thing to do in long run.

Even in a blue chip stock, if something goes wrong, one must have the ability to exit the stock in time and it is a wise thing to do. Only those people, who can act rationally, can win in stock market.

Those people, who use the weapon of stop loss at right time, are always victorious in the markets in the long run.

Primary Stop Loss: Which is a level below your Initial Buy Price

Now let us understand at what level our primary Stop Loss must be. There can a fix percentage based level, where you put stop loss at 10 %, in case of very short term swing trades, and aroud 25% in case of medium term investment horizons, below your initial buy price as per your comfort level to take loss.

I prefer active approach in which we put stop loss based on crucial supports on charts. If that crucial established support is broken then we cut losses and exit the stock.

It could be 21 day Average in case of short term established trend and it could be 50 Day Moving Average Support in case of medium term established trend.

Depending on our horizon, we must keep stop loss levels and adhere to them strictly, so that we do not suffer decision paralysis like most people do due to scenario explained above in this chapter.

Trailing Stop Loss: Which is a level above your Initial Buy Price

Trailing Stop loss is a level above our Initial Buy Price. This kind of stop loss enables us to take a certain portion of profits home in worst case scenarios.

If we are already having a profit of 75% then we need to ensure that our trailing stop loss should be such, so that we are able to take most of the profits home. We may not take entire 75% home, but we can take at least 50% home if we employ trailing stop loss technique in our portfolio. This makes sure that even if markets keep crashing, we will exit taking major portion of our profits home, and not loosing our profits and capital in Bear phase of market, like most people do.

Most people do not employ trailing stops, and even worse, they fail to employ Primary stop loss, and watch they stocks not only loosing all its profits, but getting into negative territory generating negative returns.

Trailing stop ensures that we always get a positive return on a stock that has done well for us.

People fail to put trailing stops and in most cases, even though they are making profit in some stocks, when the market’s decline they let the profits erode, and try to give themselves false consolation that only profit is lost, so not to worry. But stock market is not a place for time pass. If we are not going to take profits home then what’s the use of investing in stock market? Trailing stop is like a safety net. Which ensures that when bull run turns into bear market most of your profit on capital is taken home.