A Step To Stop

This blog’s heading contains two important key words “Step” and “Stop”

You might be wondering about the heading.

Let, me explain you

Here, Step means ‘A move’ which you take.

And,

Stop means “A Stop Loss”

So, A step to Stop means taking a move to put “A Stop Loss” while entering a trade or after entering a trade.

Yes, so who don’t understand what Stop Loss is……….

Let’s understand,

Step To Stop
  1. What is a Stop Loss?
  2. What is a Stop loss order?
  3. How does a stop Loss work?
  4. Advantages of Placing a Stop loss order
  5. Types of stop loss orders?
  6. Methods to determine where to set a stop loss
  7. Mistakes to avoid when you Place Stop Loss.

1. What is a Stop Loss?

A stop-loss is exactly what it sounds like – it stops a trader from incurring a loss or more loss. It is a very powerful tool that is available to the traders for limiting their losses.

2. What is a Stop Loss order?

Suppose you bought 1,000 shares of Trident limited @50 rupees each (Rs.50,000). you expect that the share price will increase and it will reach @60 rupees each and you will make 10,000 Rs profits (60-50=10*1000)

But, What if the price starts falling from Rs.50 to Rs.49 to Rs.48 then Rs.46.

What if price fall further and keep falling furthermore due to some unforeseen adverse event?

Well, you are lucky enough that there is a useful mechanism in the stock market called Stop Loss orders.

Stop loss order is an order which instructs the broker to sell the security if price falls below a certain level.

3. How Does a Stop-loss Work?

A stop-loss order automatically closes a losing position once the price hits the pre-specified level. For instance, if you have bought a stock at Rs 200 and you want to limit the loss at 190, you can place an order in the system to sell the stock as soon as the stock comes to 190.

4. Advantages of Placing a Stop loss order.

1) Prevent large and uncontrollable losses in very volatile trades: –

Stop loss in trading is a method that is used by traders to limit their losses. Stop loss helps you to cut your losses and insures you against a big loss in the stock market. Many a time, we suffer a big loss if we don’t place a stop order as the price falls steeply.

Help in risk management: –

Stop loss in trading helps us to minimize our losses and also ensures us against a big loss. By placing a stop loss order traders calculate how much money to risk on a single trade, what position size to take, what should be risk to reward ratio. And this helps in preventing major drawdown in capital.

2) Provides Automation: –

Stop loss in trading helps to automate our selling as we do not need to be present in front of our trading screens all the time. In simple words Stop-loss orders never sleep, they always follow the market and will close the trade almost guaranteed at the pre specified price, preventing heavy losses on a losing position.

3) Promotes discipline: –

Placing a stop-loss is a positive trading behaviour and it is really important for an investor to detach himself/herself from the market emotions. Stop loss helps you to stick to your financial plan and promotes disciplined trading.

5. Types of stop-loss orders

Stop-loss orders are of two types:

  1. Stop-loss Market orders
  2. Stop-loss Limit orders

In market parlance, they are called SL and SL-M orders.

The following example will make it clear.

    i)  Stop-loss Market orders

    Let’s recall our example you bought 1,000 shares of Trident @50 each and you are hoping as well as confident that the share price will reach @60 each. What if the price falls, unlike you’re expecting? You never know.

    However, considering your risk appetite, you can afford a maximum loss of upto Rs. 5,000 in the investment as per risk to reward ratio (1:2), and not more than that. So, you do the following arrangement –

      As you can see, the current market price of Trident limited is Rs. 53.10. and in order to protect yourself from adverse downward move you initiate a stop loss order as You mention the trigger price at Rs. 45.

      Now, once the upward trend reverses, i.e., prices start moving downwards (as against your expectations) and touch Rs. 45 (trigger price), your sell order will be active for execution.

      Meaning, your shares will be sold off at its market price prevailing at the moment the trigger is activated, most probably around Rs. 45. This way, your losses will be limited upto Rs. 5000 [(50-45) *1000], i.e., within your acceptable limits.

      Note: One thing you have to keep in mind, although a stop loss order protects you from adverse price movement but they may not always do that entirely. For example: –

      Let’s understand with our example Trident was trading at Rs 53.10 each and I placed a stop loss order at 2:50pm and the closing price till the end of the trading session is Rs.56 each. Overnight, there is some negative event in the company and the next day, as the trading day begins, Trident ltd.’s shares open at a price of Rs. 40! Mark that the opening price has already breached the trigger price (45), and hence, the shares will be sold off at the prevailing market price of Rs. 40! A straight blow of Rs. 10,000 [(50-40) *1000].

      Bad luck, now we have to bear the loss far beyond our acceptable limits. But wait, in NO way, it means that you’d avoid stop-loss orders.

      Why not use a Stop-loss to Limit order instead?

        ii)  Stop-loss Limit orders

        A Stop-loss Limit order is just a stop-loss order with a limit. In the case of SL-Limit order, when the price of an asset reaches the stop-loss price, a limit order is automatically sent by the broker to close the position at the stop loss price or a better price. Unlike the stop loss market order, which will close the trade at any price, the stop loss limit order will close it only at the stop loss price or better.

          Here, I set the trigger price at Rs. 46 and the stop-loss price at Rs. 45 (and not the prevailing market price).

          Meaning, even if the price of the stock breaches my trigger price (46), the shares will be sold only at or above the specified stop-loss price (45). Hence, my loss will be limited to Rs. 5,000 as per my risk and reward ratio.

          So, where the challenge lies?

          The challenge lies in finding the right place to set a stop loss. It is basically a matter of picking a price level beyond which a trade bias is no longer valid.

            6. Methods to determine where to set a stop loss.

            Till now it might be clear to you that, Stop-loss can be used for both short-term as well as for the long-term, but it is most effective for day traders as they have to take decision within that one single day

            Basically, there are three methods to determine where to set a stop loss –

            1) Percentage Method:

            The first way of placing a stop loss is using the percentage method in this method it is your choice to set a percentage of your loss.

            For example, if you can take a loss of 10% based on your risk appetite. Then you can place a stop loss price at 10% lower than the buying price. For instance, if you own a stock currently trading at Rs. 100 and you can afford to bear a loss of not more than 10%, then simply set your stop-loss sell price at Rs. 90. So, your maximum loss will be limited to Rs. 10 (i.e., 10% of Rs. 100).

            2) Support method:

            In this method you need to identify an important technical level (such as, support and resistance zones, trendlines, Fibonacci, to name a few.) then a trader who is looking to go long (short) would place a stop loss just below(above) an important technical level.

            The idea behind this approach is that important levels in a chart hold an increased number of buy(sell) orders as market participants who’ve missed the initial move would want to enter(exit) the market at a more favourable price.

            3) Through technical indicators method:

            The third method which is used by traders to set a stop loss is using a technical indicator (such a moving average) Calculation of moving averages could be bit complex in this limited space.

            So just know this, like the support method, in this method, also set your stop loss just below the moving average of the stock.

            * By the way, in each of the above three cases, the trigger price has to be set slightly above the stop-loss sell price (below the support or moving average, anyway).

            7. Mistakes to avoid when you Place Stop Loss:

            Here are a few mistakes that the trader needs to avoid while placing a stop loss:

            1) Percentage Method:

            Before taking the position, a trader should know where his stop is going to be. The benefit of ascertaining your stop loss before you open trade is that it removes any emotions from the decision and protects you from dumb exits.

            2) Placing your Stop Based on Arbitrary Numbers:

            One shouldn’t place their stop loss based on arbitrary numbers or we can say one should not put stop loss randomly. They should determine their stop loss based on technical parameters as discussed above.

            Conclusion:

            Now, we have to conclude our Heading “A Step to Stop”.

            In order to protect our capital and to stay for a longer period of time in stock market, we should Take a step (a move) to put stop loss on every trade doesn’t matter Whether you’re an intraday trader or a long-term investor, you must use stop losses in your trades. Stop loss not only help you reduce your risk exposure but also give you the freedom to take a breath during trading hours without having to stick your eyes to the screen all day long. So, give your eyes some rest and put your brains into action.

            Happy Learning! 

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            2 Comments

            Bhavya bansal · March 19, 2022 at 3:15 pm

            It was very informative session .

            Bhavya bansal · March 19, 2022 at 3:15 pm

            It was very informative session . Thankyou sir for giving us such useful information.

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