What is stop loss and how it is useful in trading and investing?
“Had a rough day today, “ said one frustrated trader to another. It is not hard to guess what could be the reason for this frustration… hitting a stop loss! Not accepting a stop loss, is a common mistake that traders usually make.
Before dwelling any further on this, let us first try and understand what is ‘stop loss’.
As the name suggests ‘stop loss’ is the point at which you can “stop” your potential “losses”. It is used to minimise your losses by specifying a certain predefined price at which you may close the position.
Whenever you are start trading in a particular stock, there are only two possibilities, either it will work in your favour or it will not. In both cases it is wise to accept the consequences. Trading is majorly a mind game where predominantly two emotions play a vital role, hope and fear. Retail traders will be able to relate with this fact that as soon as initiate any trade, the first emotion that pops in mind is that of fear. You are surrounded by questions such as, “What if I make a loss?” “What if I am wrong?”
After entering the trade if it doesn’t go according to your view, the second emotion that takes over the mind is that of ‘hope’. The brain starts to look for reasons to hold on to the trade, and expects that the market will oblige its view sooner or later. Unfortunately, it doesn’t happen and as a result, you end up with a bigger loss. What follows next is revenge trade and if that also goes wrong, the saga of booking losses continues, which adds to the disappointment. In the end, you not only have a loss of capital but confidence as well.
In retrospect, it is very clear that this vicious cycle can be easily broken at the very first step itself, i.e. accepting the stop loss and exiting the trade. One must understand the fact that if the trade is going 2% against you, then there is a greater possibility that it may go worse. There could be various reasons for trade going wrong, for example, wrong view, wrong trade entry, or even sudden volatility in the market.
Accepting the stop loss is one of the important qualities of the disciplined trader. To be a good trader, one must have a certain trading system that includes the trade view, the trade plan (entry, exit criteria, stop loss – target calculation), and trade management (money and mind management). A foolproof system such as this one not only allows you to make better trades (golden ratio of risk/reward is 1:3) but also to trade mechanically.
In order to follow such this system religiously, you may choose to manually add a stop loss or you can enter stop loss order in the trade itself. Even when the trade is profitable, activating trailing stop loss will ensure that profit is protected. That’s not all. While setting a stop loss, you must ask yourself this question, “how much is too much?” based on how you are with your finances. There is no doubt that adhering to the stop loss is important, but more importantly, it is money management. Calculated exposure with a risk management plan (hedging) will ensure a limited loss. Accepting the stop loss as per your system will also allow you to reanalyse the study or find better opportunities to trade.
To summarise it all, to be a successful trader, it is wise to make ‘stop loss’ your friend as it is a great capital saver. Every trader must always keep in mind the fact that “I can be wrong and the market is supreme”. If the target is your confidence, stop loss is your humbleness. And market rewards the one who has both the qualities.