Importance of Stop Loss in Trading

If you are a trader in the stock markets, you would have surely heard of the stop loss discipline. What exactly is this stop loss discipline and why is it so important for a trader in equities? In fact, whether you trade equities, futures or options, a stop loss is a necessary discipline. Many traders complain that when they set a stop loss it gets triggered on a volatile day and then the target gets achieved. That is a risk you do run but still keeping the discipline of stop loss is essential. Here are five reasons why stop losses are extremely important to you as a trader…

• As a trader you always trade with finite capital…

It does not matter whether you are a George Soros, Stanley Druckenmiller or a small trader in India. Every trader is required to operate with finite capital. A global investor like Soros may operate with a much higher risk appetite but will still be required to maintain the discipline of stop losses because capital is finite. One of the most important jobs of a trader is to protect capital from erosion and that is possible only if you maintain the discipline of stop loss. Each trader starts off by outlining the maximum loss that she is willing to take on a single trade, in a day, in a week etc. This kind of discipline can only be maintained if the stop loss is kept for each trade.

• Stop losses enable you to churn your money faster…

That is the second key task that the trader has to ensure. As a trader you do not have the luxury of buying a stock and holding on to it for a long time. Your primary task is to close losing positions, move onto another trade and look to compensate for a bad trade elsewhere. For a trader the real ROI comes from churning the capital as quickly as possible by moving in and out of positions rapidly. When you churn your money rapidly in a profitable manner, it works like the power of compounding for you and ensures profitability in your trading operations. That discipline can only be ensured through a stop loss.

• Bouncing after a loss takes a bigger effort…

This is a statistical reality when it comes to recovering losses. For example it is much easier for Rs.100 to fall to Rs.80, but a lot more difficult for Rs.80 to bounce back to Rs.100. Consider the table below…

The table above is fairly self explicit. A 10% loss requires an 11% appreciation to come back to status quo. A 30% loss requires a 43% bounce to regain status quo. But, when a stock corrects by 50%, then even after a 100% bounce, the stock is only back to the buying levels. That is why short stop losses are a must because the longer you wait, the momentum is going to be increasingly against you!

• Stop losses are critical to avoid the risk of concentration of positions

Concentration can happen in select stocks or sectors. Whether you are a trader or an investor, if you keep holding on to positions or averaging them you run the risk of increasing your exposure inordinately. If you bought a stock at Rs.75 and if it comes down to 65, then you are tempted to average your position to reduce your cost of holding. If it goes down further you may be again tempted to average your position. This is not really going to help you because you are committing the same mistake again and again. You would have been better off cutting the position at the first instance with a stop loss. The discipline of stop loss ensures that you do not end up overexposing yourself to the risk of few positions.

• Concept of stop loss is quite flexible in terms of application…

The concept of a stop loss is quite flexible in terms of application in practice. In fact, there are a variety of applications to the concept of stop loss. Firstly, you can use it to keep a check on the risk of your trading positions. This is the basic role of a stop loss. Secondly, you can also apply this concept when the stock price is rising and use the concept of stop-profit or trailing stop losses to constantly keep upping your targets with in-built risk management.

• As a trader you can get higher leverage while trading…

Before we get into this point, let us understand what trading leverage is all about. When you buy a stock for investment then you pay the full price and hold on to the stock for the long term. But that is not the way you trade stocks. You churn money and you ensure that you are able to trade much higher quantities using your funds as a margin. Let us understand this point in greater detail…

Trader Ashok has put in a margin of Rs.50,000/- into his trading account. He now wants to trade Reliance for intraday at the current price of Rs.920. With his margin he will be able to buy around 54 shares for delivery. Since the order is an intraday order and Reliance is a highly liquid counter, the broker feels that he can be allowed to take a 3 times leverage. That means, against a margin of Rs.50,000, Ashok can be allowed open positions up to Rs.150,000. Thus Ashok will be able to leverage himself to buy up to 162 shares of Reliance for intraday trading purpose.

Now, Ashok wants to know if he can leverage himself still further. The broker agrees to give Ashok a leverage of 7 times, provided he is willing to place a cover order. Before we get into the nuances of a cover order, let us look at what 7 times leverage means. It means that with a margin of Rs.50,000, Ashok can take intraday trading positions up to Rs.350,000. That means Ashok will be allowed to buy up to 380 shares of Reliance for intraday trading purposes because it is a cover order. In a cover order, you place a stop loss at the time of placing the order itself. While placing an order to buy 380 shares of Reliance at Rs.920, Ashok places a stop loss at Rs.902 since the technical support for RIL is at Rs.905. At the stop loss level of Rs.902 Ashok’s trading risk is just Rs.6,840/- {380*(920-902)}. Since there is a margin of Rs.50,000 in Ashok’s account, this cover order reduces the risk of the broker substantially. That is how cover orders (with in-built stop losses) can be used to increase your leverage for intraday trading!