Successful traders identify their profit and loss parameters when they enter a trade. As the name suggests, ‘Stop Loss’ is used to limit a person’s loss in a trade. It is in the trader’s interest to enter a stop loss order while entering any position with a trading view, as it will protect them from an unreliable technical indicator/event and keep them emotionally neutral while executing their trades which is the key for long term trading success.
Determining where to put a stop loss is a difficult question for any trader. Setting stop loss too far away can mean losing more money in case the stock moves in the wrong direction. On the other hand, putting stop loss levels too close will mean losing money by exiting out of the trade too early. Where to place a stop loss depends on the individual trader’s risk appetite and their perception of future profits from the trade.
Where to set your stop losses:
There are four basic methods that can be used to determine where to set your stop losses:
The Percentage Method
The Percentage Method is the most simplest and the most used method of determining stop loss order. In this method, the trader will determine the stop loss by determining the percentage he is willing to forgo before he exits the trade. For Eg. If a trader executes a trade at Rs.100 expecting the price to move to 110, a potential 10% profit, the traders risk profile dictates what price to use as stop loss, a conservative trader might be willing to accept a loss a 3% for a potential 10% profit while a trader with a higher risk appetite might be willing to risk 5% or higher for a potential return of 10%.
The Support Method
The Support Method uses technical analysis to determine supports and use them as stop loss. First the stock’s latest support level is identified then the stop loss is placed a little below the support level so as to leave a little room for any error that may have occurred during the calculation of support levels. For example: If a trader bought a stock at Rs 100 and determines that the latest support level for the Stock is Rs 90, then he can place the stop loss below Rs 90.
The Moving Average Method
The Moving Average Method uses moving averages to determine the stop loss. Generally traders use a longer term moving average rather than the shorter term moving averages so as to avoid setting stop loss too close to the price of the stock and exit out of the trade too early.
Trailing Stop Loss
Trailing Stop Loss is another concept that can be used by traders to protect their profitable trades and continue to ride the momentum while at the same time protect their profits in case of an adverse turn in prices. For Eg., A trader has entered a trade at Rs. 100 with an initial Stop Loss of 97 and the price has moved up to his/her target price of Rs. 110. In case the trader feels that there could be more upside left, they can move the stop loss from 97 to 108, this way they are able to protect their profits while at the same time ride the upward momentum.
Finally, Trading inherently carries risk and putting a stop loss is a way of managing that risk and there by protecting capital.
Irrespective of the method used to determine the stop loss, developing a habit of placing stop losses in trading and investing would greatly help in limiting losses and locking profits.