What is Stop Loss?
Stop Loss is the crux to limit trading risk, to remove emotions from decision making and it also aids the trader to gain better control over their trade. Stop Loss is generally used by a trader who intends to enter a trade with a short term/intraday view. The beauty of Stop Loss order is that it costs nothing to implement. However, the regular commission is charged only once the Stop Loss price has been reached and the stock must be sold.
How does Stop Loss work?
Stop Loss is an order placed to Buy or Sell once the stock price hits a particular predetermined trigger price. The order is executed without any human intervention. While having multiple trade positions in open market, Stop Loss order assists the trader from getting caught on the wrong side of a trade, which in turn serves as a protection from excessive losses.
Why is Stop Loss important?
Apart from protection from excessive loss, Stop Loss order can be very handy when it comes to multiple open trades. At times for a trader it is difficult to monitor the changes in markets throughout the day, which can leave a trade open to volatile moves. In this scenario, setting a Stop Loss order will be a smart move to protect the trader from unbearable losses.
Trailing Stop Loss, vital tool to protect gains
A trailing Stop Loss comes into picture once the price of a stock/index moves in favour of a trader. It is generally applied to protect gains. When a trader implements trailing Stop Loss, it enables an open position that will let the trade ensue its ongoing momentum and continue to profit till the price is maintaining the requisite direction. A trailing Stop Loss gets triggered if price alters direction.
For example: You open a long trade in Reliance Industries (RIL) at Rs 1450, set the Stop Loss rate at 1440 (10 points Stop Loss) and you expect target of 1470. If price rises to Rs 1460, then by using the trailing Stop Loss tool, one can raise the original Stop Loss of Rs 1440 to above cost i.e. at 1452 (subjective to the trader). Thus, ensuring there would be Rs 2 gains going forward in the trade.
However, if RIL moves lower, for instance to 1448, the Stop Loss level will remain the same.
How to set a Stop Loss:
- As per traders’ discretion or loss he is willing to take.
- Support & Resistance method
- Moving average method.
As per traders’ discretion or loss he is willing to take.
Before taking a trade, a trader has to decide on how much risk he/she is willing to undertake in a particular trade. It is important for a trader to evaluate ones risk taking appetite to effective engage in trading activities. It is always advisable to have in place a risk calculation mechanism for each trade.
Support & Resistance Method
Historically, it has been observed that price of stock/index starts falling and suddenly halts at particular support levels. It is always logical to set Stop Loss immediately below these critical support zones.
For example: Trendlines are the best way to identify support and resistance.
Bank Nifty Monthly chart
The Moving Average Method
Adding Moving Average to a stock/index chart which is under consideration and using this as another method to identify Stop Loss. Generally, it is advisable to use a moving average which suits a particular stock/index. This would ensure and also avoid setting Stop Loss too close to the price of the stock/index and getting whipped out of the trade too early.
Once the moving average is inserted, all that is needed to be done is to set Stop Loss immediately below the level of the moving average.
For example: In case of Nifty, the 33 Day EMA is the perfect moving average that suits the Nifty index.
Nifty Daily Chart