When it comes to trading, one of the oldest adages is to cut your losses and let the winners run. Though it sounds simple, ask any trader and he will tell you how difficult it is to cut the losses and allow winners to run.
Most traders, especially during their formative years, end up doing the opposite–cut the position as soon as it is in a winning position for fear of losing and holding on to their losses, hoping to recover the losses. Trading is considered a mental game rather than one of strategy for this reason.
A professional trader would cut his position if he feels the premise for taking the trade had gone wrong. But a rookie trader does not have the discipline to cut his losses.
Thankfully, electronic trading now has a provision to allow traders to come out of a losing position mechanically. The process is called putting a Stop Loss order.
Take, for example, a trader who has bought a share for Rs 500 with the hope of the price moving higher to say, Rs 550. On the downside, he feels that if the price goes below Rs 490, then the chart pattern based on which he had taken the trade does not hold.
To prevent his trade from incurring unlimited losses, he will place an order in the trading system which will help exit his position if the price touches Rs 490.
Similarly, in case the trader has taken a short trade (where he sells a share or a derivative instrument without owning it) based on a chart pattern, he can prevent his position by placing a stop loss.
Assuming the trader feels the market is looking weak and sells Nifty at, say, 17,000 with an expectation of the price touching 16,800. However, the pattern will not hold if the price crosses above 17,050. In this case, the stop loss order will be placed around 17,050 and the trader will be out of the trade if the price moves higher.
Some traders place their stop loss order based on their risk profile. If the maximum risk a trader is willing to take is say, Rs 1,000, then, in that case, he would keep his stop loss at a point where the loss will not exceed Rs 1,000 if the trade goes against him.
In the short sell example of Nifty mentioned, if the maximum loss a trader can afford is Rs 1,000 then he will place his stop loss at 17,020. Since Nifty has a contract size of 50 units of Nifty, a 20 point stop loss would result in a loss of Rs 1,000. (50 units of Nifty X 20 points = Rs 1,000).
In the example mentioned above, if the stock bought at Rs 500 starts moving higher and touches Rs 515, the trader can move his stop loss from Rs 490 to the recent low or based on any other indicator, say, at Rs 505. As the share price continues to move higher, he can trail the stop loss until his target is achieved or the stock breaks through his stop loss level.
A stop loss order can be used for money management. Continuing with the same example of the share bought at Rs 500, suppose a trader has designed a trading system that allows him to take a maximum risk of Rs 2,000 per trade. Now in the example, if the trader has taken an entry and kept his stop loss at Rs 490, he will risk a maximum of Rs 10 per share. To risk Rs 2,000 on the trade, he can buy 200 shares (maximum risk of Rs 2000 divided by maximum risk of Rs 10 per share) of the stock. Rather than trading with a fixed amount, the trader can use the stop loss to optimize his position size. This approach of trading is called position sizing.
The one reason why rookie traders avoid putting a stop loss order is that they feel the market comes down to their stop loss level only to take them out and then move in the direction in which they intended to move. This is because most traders keep their stop loss at the most obvious points, which professional traders generally exploit.
In a range-bound market, stop losses are regularly hit, which will test the patience of a rookie trader and make him shift his trading strategy. A professional trader knows that there will be times when his strategy will face drawdowns because of repeated stop loss, a phenomenon that is commonly known as whip-saw n trading parlance.
There are times, especially during a fast move, that the stop loss order will not get executed as the market will jump above or below the order, resulting in higher losses to the trader. Such slippages are the worst enemy of a trader and require the trader to continuously monitor his trade despite placing the order.
Stop loss orders, in most cases, have to be put every day as they are in the system only till the end of the day.
Earlier, there were two ways of placing a stop loss order–a Stop Loss limit order (SL order) and a Stop Loss Market order or an SL-M order. However, the stop loss markets order has been discontinued by the Securities Exchange Board of India (SEBI) as it resulted in sharp swings in prices of illiquid instruments, especially illiquid option contracts.
We shall therefore consider how to place a stop loss limit order in case of a buy trade and a short sell trade.
A stop loss limit order means that the trader has defined the price limit beyond which he would not like to be in the trade.
Let’s consider a buy example first where shares are bought at Rs 500 and the trader wants to put a stop loss at Rs 490.
Since the trader has bought the shares, a stop loss order should be of a sell position that if hit will take him out of the trade.
To place a stop loss order, two sets of prices have to be placed–an SL limit price and a trigger price. If the market price reaches the trigger price, the stop loss order of the trader will get activated and the trade may get executed if the price is around the same stop loss level or between the limit and trigger price.
A trigger price is always above the limit price. In the present example, a trigger price will be at Rs 490 and the limit price can be Rs 489.50. This gives a range for the order to get executed.
With a sell trade, as mentioned in the example above, a short position is created at 17,000 and the stop loss is at 17,020. Here, the trigger price will be below the limit price.
The trader will put the trigger price as 17,020 and the limit price as 17,021, giving a range of 1 point for the trader to exit from the position.
Trading without a stop loss is considered as going to war without armour or driving without a helmet. Stop loss is the cost of trading successfully. The earlier a trader appreciates the value of stop loss, the faster will he become successful.
Stop loss is a risk and money management tool. It is used to prevent losses from going out of hand. Stop loss can be put on both long and short trades.
A stop loss order is a risk management tool where the maximum risk per trade is known as soon as the trade is initiated. A stop loss order is not only used to reduce losses but also to achieve maximum profit by following what is called the trailing stop loss.
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