How to Set Your Stop Loss in Trading?

A successful self trader – Rule # 44

Stop loss is one of the critical pillars of equity trading and investing. You trigger a stop loss when the price movement goes against you. Your stop loss is normally determined by two factors viz. What the technical charts suggest and how much loss you can afford. A trade without a stop loss is like a life without insurance. The benefits may not be visible but the risks of not having it can be humungous…

The Endearing Logic Of A Stop Loss

When you create a trading rule book, the idea of stop loss forms a very important constituent. A seasoned trader in any market never ventures without a stop loss. Stop loss is a must, whether you are a trader or an investor; whether your view is long term or short term. Stop loss is the level or situation when it makes more economic sense for you to exit the trade, rather than to stay on.

But why is a stop loss so important? Investing is never a one-way street. The best of traders, probably, get 60% of their trades right. What makes them successful is that they exit losing trades quickly and hold on to their winning trades long enough. A stop loss frees up your liquidity, protects your capital in volatile markets and ensures that you live to fight another day.

Stop loss also has a psychological underpinning. Let me illustrate. Most traders get into a trade with the assumption that their view is right. It becomes difficult for them to admit that the view was wrong and hence they tend to hold on to positions. A stop loss builds in an automatic discipline into a trade. Thus you are rarely illiquid when the next opportunity arises.

But, How To Set A Stop Loss?

Technical Charts Are Your Primary Driver

Ask your advisor or consult an online chart for supports and resistances. A long trade sets a stop loss below the support and a short trade sets a stop loss above the resistance. Provide for market liquidity when you set a stop loss.

Adjust Your Stop Loss For Key Market Events

A stop loss is not just technical, but also fundamental. If the company reports bumper profits, widen your stop loss. If the budget is disappointing, narrow your stop loss. Also consider global macro factors to fine tune your stop loss levels.

Use The 10% Stop Loss Rule In Leveraged Trades

Leveraged trades like intraday positions, futures and short options must follow the 10% rule. At no point must more than 10% of your capital be risked by your open leveraged positions put together. This overrides 1 & 2.

“Being wrong is ok. It is how much money you lose when you are wrong, that really matters” – George Soros

5-Things To Know About A Stop Loss

  1. A stop loss should be used as a risk control measure. Don’t use a stop loss level to blindly double your bets. If you stopped out your long trade of Rs.150 at Rs.145 and if stock goes down to 135 don’t jump in to double up your trade. It is ok to be wrong once, but you cannot be wrong twice.
  1. A long term holding can also have a stop loss. That is usually referred to as a trailing stop loss which constantly gets reset as the stock or index continues to move in your favour. The idea of a trailing stop loss is to protect your gains in the event of any negative market events.
  1. Don’t ever look at the stop loss as a regret level. Let me explain. It often happens that your long trade hits a stop loss and then bounces up. Don’t treat this as an opportunity loss. Remember, that a stop loss is about protecting your capital, not about whether your trade was right or wrong.
  1. You can also set indirect stop losses by buying options. But remember option buying has a cost. You can also use reverse futures as a stop loss but they run the risk of mark-to-market margins. And as Buffet said, “At their worst, some derivatives can be weapons of mass destruction”. Watch out!
  1. Lastly, when you place a stop loss, the volume and order book matters. Place the stop loss at a level which shows sufficient supply and demand, depending on your trade direction. Stop losses, essentially should be market orders so you don’t want to see illiquid drops. Also select the less traded strikes so that you are high on time priority.

Experiencing Stop Losses In Action

As a trader, stop loss can give you a lot of heartburn. I have seen traders who trigger their stop losses at 1% below the buying price and the same day the stock touches the upper circuit. This can be disconcerting. But worse still is the case of Sharad Shah (name changed to protect identity). He bought Himachal Futuristic in 2000, did not put a stop loss and saw the stock at lower circuit with only sellers for 3 consecutive days. The same thing happened to Satyam and Financial Technologies at the peaks of their crisis. Stop loss sure helps!

Remember, we are in a market where FII selling can destroy the prices of blue chips in a single day. Also most blue chips, which are included in the F&O segment, do not have any circuit filters, meaning they can correct to any extent in a single day. We have seen that happen in 2009 at the peak of the pledged shares crisis in stocks like Orchid Chemicals, Wockhardt Pharma and Polaris and much later in Global Telesystems and Gitanjali Gems. Only a stop loss works in these conditions.

Takeaways From The “Stop Loss” Argument

As George Soros himself admitted, he never gets into a trade without a stop loss. Even when Stanley Druckenmiller, of the 1992 pound short trade fame, undertook to short sell the pound he did it with a wider stop loss. Also he was extremely clear that if the loss exceeded the 12% ROI that the fund had already made during the year, they would exit the pound trade. It is a different matter that the trade earned them $ 1 billion, but there was no compromise on the stop loss principle.

To paraphrase and adapt Henry Ford, “Having trading discipline is the beginning; keeping discipline is progress; but only staying disciplined ensures success”. And nothing embodies trading discipline in markets better than the act of setting, following and closely monitoring stop losses. Rather the pain of discipline than the pain of regret!

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