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Understanding the nuances of setting stop losses for trading

21 Feb 2023

For any trader, setting stop losses forms a part of the cardinal Bible of trading. What exactly is a stop loss? Irrespective of whether you are trading long (buying) or trading short (selling), a good trader always puts a stop loss and trades. A stop loss is a worst case scenario for your trading position. Let us understand stop loss with 2 different trading positions
Assume that you have bought 100 shares of Infosys at Rs.940. You are willing to take a maximum risk of Rs.10, then your stop loss should be placed at Rs.930. if Infosys touches Rs.930, you just book the loss and terminate the position. Alternatively, assume that you have sold 50 TCS shares at Rs.2345 and are willing to take a maximum risk of Rs.20. Since this is a short position, you can place the stop loss at Rs.2365. At that point, you book the loss and terminate your position.
Why stop losses are so important for a trader?
The most important consideration for a trader in equities, derivatives or commodities is not about making profits but about protecting the capital. As a trader, you always want to risk only a small portion of your capital on each trade. If you have taken a trading position and the price has moved against you, it means that your position was wrong in the first place. Instead of waiting in hope, it makes more sense to book the loss and move on. Stop losses ensure that you can survive as a trader for much longer.
Stop losses are the key to sustaining your liquidity
For a trader in the financial markets, liquidity plays an important role. This allows the trader to capitalize on opportunities as and when they arise. The beauty of the stop loss is that it ensures that you are liquid when it matters the most. If you bought a stock and the stock corrected sharply, then without a stop loss you will be left holding paper when the markets are down. In the process you will miss out on other buying opportunities.
Where to set a stop loss – The affordability clause
One of the simplest and intuitive ways of setting the stop loss is through the affordability clause. Let us say, you set a rule that you will not stake more than 0.5% of your capital in a single position. Your stop loss should be set accordingly. As mentioned earlier, the most important purpose of a stop loss is to ensure that your capital is protected; that is how much you can afford to lose on a trade.
Where to set the stop loss – The technical levels
Setting stop loss based on affordability makes good economic sense to protect your capital but it is not exactly a scientific approach. A better approach would be to use technical support and resistance levels to set a stop loss. So if you are long on the stock then you set the stop loss slightly below the next support. If you are short on the stock then you set the stop loss slightly above the next resistance level. This small gap is provided to take care of spikes in volatility. Technicals are based on empirically proven charts which observe long term patterns and bet on these patterns repeating. While they are not exactly fool-proof, they offer a good starting point.
Should stop loss be indicative or set in the system
A normal question in the minds of traders is whether they should leave the stop loss as a flexible range or make it a rigid level and impute it in the trading discipline. It is always better to opt for the latter. Setting a specific stop loss instils a discipline in trading and the execution happens automatically when the stop loss gets hit. When it is discretionary, there is the human tendency to wait a little longer. That lack of discipline can be dangerous in a volatile market.
Is stop loss a guarantee that losses will not be worse?
That is true in case of very liquid stock, but may not necessarily be true for less liquid stocks that have wider bid-ask spreads. On volatile days we have seen the bid-ask spreads widening sharply and that means your actual execution price may be worse than the price you are looking for. In such cases, your actual loss due to the stop loss will be more than what you had originally anticipated and provided for. That is a risk you are exposed to in volatile markets, but as we said earlier, that risk is more pronounced in mid-cap stocks and illiquid stocks, not so much in liquid A-Group stocks.
Understanding the concept of position termination in investments
One question is whether you require stop losses when you are invested from a long term perspective? Technically you may not require a trading stop loss in such cases. However, you need to use some proxies to judge whether you need to revisit your position. Normally, the stock price breaking below the 100-DMA and 200-DMA are indicators that something is wrong with the stock. There are cases of company performance worsening as we saw in the case of Kingfisher, Satyam and Deccan Chronicle. Then there are cases where stocks have gone into structural bear markets for a prolonged period of time. PSU banks post 2013, Capital goods stocks post 2012 and IT and Pharma stocks post 2016 are all cases in point. In such cases also, there is a strong case to terminate your position and either shift to a different position or wait for the fog to clear.
Using trailing stop losses effectively
A trailing loss is set when you are already sitting on a profit but see the momentum continuing. In such cases, you can set a trailing stop loss to lock in your profits and ensure that even in the event of a fall in price from higher levels; your profits up to a certain level are protected. Long term investors use trailing stop losses quite effectively.
To conclude, the concept of stop loss is intended to limit your downside risk, protect your capital and instil trading discipline in you. After all, in the long run it is discipline that matters in trading; much more than how often you are right on your trading calls!

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