The Stock Market is unique and full of uncertainty. In real-time the markets are complex, but after the fact everything looks simple. It’s this dichotomy that tricks many into thinking that there is easy money in the stock market. But it’s not.
As an investor or a trader you can hopethat a stock to go up or down, but you can’t control it. Stock market is a collective reflection of thousands and millions of participants and no single entity has any control over it.
You are dealing with geopolitical, environmental, financial, technical, human and many other uncontrollable factors every single day. Controlling the downside (loss) is the only control you have to address numerous challenges everyday.
Why use Stop Loss?
Here are basic steps that you have control over in the stock market:
Which stock to buy?
When to buy and quantity?
When to sell?
Mostly people can answer the first questions with some confidence. It’s the “when to sell” that’s hardest in the stock market. If the stock has moved in your desired direction then selling is somewhat easy.
So, lets focus on when the stock has moved in the opposite direction and there is a loss. Many of us are reluctant to sell and close the position when there is a loss. Even if it’s is a small loss, it’s against the human nature to accept defeat.
Often times a small loss turns into a major setback – both emotionally and financially.
A stop loss strategy addresses this problem. When you buy a stock knowing how much you want to risk, you have accepted the consequences. You can place a stop loss order and take control of your stock position.
Winners use Stop Loss.
Risk Management with Stop Loss
The deeper the losses the longer it takes recover to get back to break-even.
Let’s say you have a $100 stock and you sell it at 5% loss ($5). Now you are left with $95 capital.
If you recover just 5% on your next trade you are at an overall loss i.e. $95*5% = $99.75.
Therefore, you will need to recover 5.26% to break-even i.e. $95*5.26% = $100.
Recover to break-even
The table above highlights the effort required to break-even. To stop the situation from getting out of control, it’s important that you enter stop order as soon as the stock position is filled. Think of this stop order as an insurance to protect you in case the trade goes against you.
If your stop loss order is triggered:
You are protected from deeper losses
You now have the capital available for other trades.
Types of Stop Loss orders
A sell stop order is used to protect long positions by triggering a market sell order if price falls below a certain level. It can be used to limit the losses or to lock in profits as the price keeps moving higher.
Similarly a buy stop order is used to protect short positions. A buy stop order is triggered when the price moves higher to limit the losses. It can be used to limit losses or to lock in profits as the price keeps going lower.
A stop limit order is similar to stop order but there is an additional limit price at which the order is executed. There are two price levels specified in a stop-limit order; the stop price that will convert the order to a sell order and the limit price.
Instead of the order becoming a market order to sell, the sell order becomes a limit order that will only execute at the limit price or better.
A sell stop-limit order is used for long positions and buy stop-limit is used for short positions.
Examples of Stop Loss Charts
Charts showing how a stop loss order prevented larger losses.
Cut your losses sooner rather than later. The deeper the losses, the longer and harder it gets to recover.