What is stop loss?
A stop-loss is a risk management tool used by investors and traders to limit their potential losses on a stock or investment. It is essentially an order placed with a broker to buy or sell a stock once the stock reaches a specified price, known as the "stop price." The purpose of a stop-loss order is to help investors minimise their losses in case the stock price moves against their expectations.
How does stop loss work?
Here is how a stop-loss order works:
- Setting the stop price: When an investor buys a stock, they can simultaneously place a stop-loss order with their broker. The stop price is the price at which the stop-loss order is triggered.
- Triggering the order: If the stock price falls to or below the stop price, the stop-loss order becomes a market order and is executed at the prevailing market price. If the stock is rising, the stop-loss order remains inactive.
- Limiting losses: The purpose of the stop-loss order is to limit potential losses. By having a predetermined exit point, investors aim to prevent significant losses in case the stock price moves adversely.
- Market volatility: In highly volatile markets, prices can change rapidly. A stop-loss order helps investors respond to such rapid price movements and take action to protect their capital.
How to calculate stop loss?
Understanding how to calculate and implement a stop-loss order is crucial for effective risk management in the stock market. Let us break it down using an example:
1. Initial purchase:
- You decide to buy 50 shares of a company at Rs. 200/share.
2. Setting the stop loss:
- Concerned about potential losses, you set a stop-loss order at Rs. 180. This means that if the stock price falls to Rs. 180, your long position will be automatically squared off.
3. Scenario 1: Stock price moves up to Rs. 220:
- Your analysis proves accurate as the stock price rises to Rs. 220.
- Profit per share: Rs. 220 (selling price) - Rs. 200 (purchase price) = Rs. 20.
- Total profit: Rs. 20/share × 50 shares = Rs. 1,000.
4. Scenario 2: Stock price dips to Rs. 180:
- The stock price falls to Rs. 180, triggering your stop-loss order.
- Maximum loss per share: Rs. 200 (purchase price) - Rs. 180 (stop-loss price) = Rs. 20.
- Total loss: Rs. 20/share × 50 shares = Rs. 1,000.
Where to set my stop loss level?
Setting an appropriate stop-loss level is a critical aspect of risk management when trading in the Indian securities market. Here are three commonly used methods to determine where to set your stop-loss level:
- Calculate stop loss using the percentage method:
The percentage method involves setting a stop-loss level as a percentage of the purchase price. This method allows traders to adapt their risk management strategy based on the volatility of the stock. A common practice is to set the stop-loss level between 1% to 3% below the purchase price. For example, if you buy a stock at Rs. 300 per share, a 2% stop loss would be triggered at Rs. 294, helping you limit potential losses while accommodating normal market fluctuations. - Calculate stop loss using the support method:
The support method involves identifying key support levels on a stock's price chart. Support levels are areas where the stock has historically had difficulty falling below. By setting the stop-loss just below a strong support level, traders aim to avoid significant losses in case the stock price breaks through that support. This method relies on technical analysis and chart patterns to make informed decisions about where to place the stop loss. - Calculate stop loss using the moving averages method:
The moving averages method involves using moving averages to determine the stop-loss level. Traders often use simple moving averages (SMA) or exponential moving averages (EMA) to smooth out price fluctuations and identify trends. A common approach is to set the stop-loss just below a key moving average, signalling a potential trend reversal. For instance, if a stock is trading above its 50-day SMA, setting the stop loss just below that level might be considered a prudent strategy.
Putting it into practice - choosing the right method
Selecting the most suitable method depends on your trading style, risk tolerance, and the specific characteristics of the stock you are trading. Some traders may prefer the percentage method for its simplicity, while others might rely on the technical analysis provided by the support or moving averages methods. It is essential to consider the individual characteristics of each stock, market conditions, and your own risk tolerance when determining the appropriate stop-loss level.
Conclusion
Strategically setting your stop-loss level is a crucial step in managing risk and protecting your investment capital in the dynamic Indian securities market. Each method has its strengths and weaknesses, so it is advisable to experiment and find the approach that aligns best with your trading goals and risk tolerance.
