Importance of setting Stop Losses

Many times I have heard statements from traders who say something like, “I bought XYZ stock with the intention of day trading, but because it turned it into a loss, I converted it into delivery (i.e. a short-term to long-term investment).” This kind of strategy is a recipe for disaster for any portfolio and let me explain why.

No trader is immune to losses in the market, and independent of the trading strategy you use or how good you are, your decision can still go wrong. Successful traders of course have good strategies which give them profits, but they also cut their losses short when the trade goes against them. In fact, one of the most important tenets of a successful trader is to limit the losses in such a situation, and the way to do that is by setting a stop loss. For novice traders, stop loss is a price at which you exit your trade when it turns against you.

Why is setting a stop loss important? Let’s see with a simple example. Suppose you were to buy a Rs 100 stock and instead of going up, it started going down. Let’s say you did not set a stop loss and it went all the way down to Rs 50. In such a case, you have to wait for the stock to come to Rs 100 just to break even, forget about making money.

In other words (and lets put this down in bold and italic as its so important),

If a stock goes down by 50%, you need to have a 100% gain just to break even.

Anyone who has invested or traded in the market knows how hard it is to have a 100% gain ( which is the same as doubling your money). This is the reason why you should set a stop loss on every trade you enter.

So what stop loss should you set? Although the stop/loss criteria can differ from person to person based on their risk tolerance, it is generally a good idea to put a 7-10% stop loss if you are a short-term or long-term trader (i.e. you sell if the stock falls 7-10% below your buying price, and buy back if you are short and the stock rises 7-10%) . If you are an intraday trader though, the stop loss needs to obviously be much less (maybe 0.5-1%). This small stop loss criteria and the volatility in the Indian markets sometimes make it very hard for a novice day trader and that is the reason why I don’t recommend day trading for traders just beginning with Technical Analysis. Beginners should first start with short-term trading and only when they have gained the confidence in making the right Buy/Sell decisions with Technical Analysis, should they venture into day trading. In India, there is a lot of attraction towards day trading because of the low amount of capital required, but one should keep in mind that just because of the low capital requirement you don’t want to join the majority of day traders out there who lose money (and no I am not making it up, the statistics say that majority of day traders lose money, and most of the times these are novice traders who have got into day trading listening to someone’s stock tips or without learning Technical Analysis)!

So, remember, the next time you enter a trade, also fix your stop loss price so that you exit the trade and cut your losses short.