STOP LOSS : MORE YOU DELAY MORE IS YOUR PAIN !!!

Friends, as markets tanked on budget day, my inbox was full that evening, with many of my fellow reader’s pouring in their queries on stocks – saying "What should we do. The stocks are down by 15 % - 20 %". I casually - said "Sell if your stop loss is triggered" – “But it’s a loss of more than 10 % and I am losing a lot out of it”, I started answering to this question by giving them an explanation and the reason behind to keep a stop loss- just then a thought strike my mind that lets have a post on importance of stop loss mechanism. 

Friends’, dealing in stock markets is dealing with volatility, uncertainty and market factors which are beyond one’s control. Many among us, or almost everyone at some point of time must have experienced that “whenever I buy, the stock is down the very next moment and the stock goes up whenever I sell”. This happens because we fail to understand the stock market behavior. Many investors among us are reluctant to book their losses. The problem is we always want to see our money growing. We never ever think of selling off the stock once it starts falling, on the contrary we start questioning ourselves "what if that this counter goes up after I sell it in the losses". This “What if” is a psychological nature of us which always challenges our emotions and costs dearest to our wealth. We hold on to that stock hoping it to bounce back and ultimately it makes you realize that you are too late to sell, making you an compulsory investor. The problem here is that we don't have a proper stoploss.

If you go through my blog posts where I always quote my views on any particular stock with a stoploss, and always without fail I mention that I respect the markets and will sell once the stoploss is triggered. Keeping a strict stoploss will not only protects the capital but it also allows to invest in any other better option. Suppose, if you buy a stock at Rs. 100 and it goes down by 10 % your loss is of Rs. 10 – as usual reluctantly people don’t like to sell at loss, so hoping for the stock to bounce back he will hold on to it, further the stock tanks another 10 % making losses to go up from 10 % to 20 %, now you are more reluctant to book losses and now you start saying that you are a long term investor knowing very well that it will take a very long time to break even.

Let’s take a simple mathematics drill which will make you understand the importance of keeping a stoploss.

Example: If you buy a stock at Rs. 100 and maintain a strict stoploss of 8 %, suppose if it falls to Rs. 92 hitting your stoploss and you don’t sell, then the same stock will need to jump 8.7 % to get back your break even point of Rs. 100. Similarly, in the table given below explains that the Longer you hold on to your losses, the Harder it is to get back your money.    

Percentage Loss	Percentage to Break Even
8.00 %	8.70 %
10.00 %	11.10 %
20.00 %	25.00 %
40.00 %	66.70 %
50.00 %	100.00 %
60.00 %	150.00 %
80.00 %	400.00 %

The table above will indeed help you in making the hard decision in easy way. This stoploss mechanism also pertains to the best fundamental stocks like Larsen & Tubro – suppose you buy Larsen for the long term say for 6 months at Rs. 1400 and if it goes down further to Rs. 1288 showing you losses of 8 %, you sell at Rs. 1288 as your stoploss of 8 % is triggered. Selling at stoploss will not only protect you with further down side but will also provide you with an opportunity to enter back in L&T when it tanks further at Rs. 1185. As L&T commands best fundamentals you decide to jump on to it at Rs. 1185 (off course this time too with strict stoploss of 8 % or Rs. 1090), it’s of more of the probability that it will bounce back once the sentiments of the markets improve hence giving back your money with profit of 18.14 % (buying at Rs. 1185 and selling it at Rs. 1400).

Choosing the correct stoploss here is a key; if you are a long term investor with moderate risk taking ability then you should go for 8 % as your stoploss trigger, but if you are a trader than Trialing Stoploss using Average True Range or ATR will serve you better. ATR was developed by J. Welles Wilder is an indicator that measures volatility. This number does not provide an indication of Price direction but it only provides an volatility and slightly modifying this number will make this number easy to understand; this is calculated by subtracting current High & Low of the stock and then multiplying it by 2, further dividing it by the days close. Suppose you are trading ACC today you would set your trialing stop loss as - 

Previous Days Close = 1221.35; Previous Days High = 1259.70; Previous Days Low = 1211.10; so subtracting days high & low i.e. 1259.70 - 1211.10 = 48.6

2*48.6/1221.35 = 7.95 %   

What are you doing here is you are simply attaching a risk tolerance level i.e. 2 based on the stock’s intraday moves averaged over a period of time. Here your stoploss for ACC should be 7.95 % from today's close. This is an indicative levels and just gives an rough idea about the volatility that stock may face in respect of prices the next trading day. And this should not be taken as a thumb rule.   

Some Key points before executing a trade:

• A stoploss should be considered & decided before a position is entered.
• A stoploss should be placed immediately at the time of entry.
• A stoploss should not allow more than 2 % loss of your account balance.
• Only risk 1 % of your total trading capital on any one trade - when you loose 2 % on that get out of that trade. 
• For the day trades a stoploss should not allow more than 1 % loss of your account balance.   

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