If you are a trader or a short term investor, you are very well acquainted with the concept of ‘stop loss’. A stop loss puts a limit on the amount of loss a person is willing to sustain should the trade go against him. Hence, the stop loss determines the financial situation and risk appetite of the individual trader or investor.
But, many a times, after getting ‘stopped out’ in the trade, the price bounces back in favour of the trader or investor, at which point the trader or the investor might get the feeling that if he/she had not put a ‘stop loss’ he could have made a profit on the trade instead of incurring a loss. But this reasoning is a fallacy because instead of the price bouncing back, if the price continued in its movement against the trader, the amount of loss would have been very high.
Take, for instance, the case of Divis Laboratories. The price of this stock crashed on December 23, 2016 due to the adverse US FDA report on its facilities. On that day, the stock slumped from a high of around Rs 1108 to a low of around Rs 801, a loss of Rs 307 or 27.70% on a single day. If the trader had gone long at Rs 1100 with 100 shares, he would have lost more than Rs 30,000 on a single trade on a single day. However, if he had kept a stop loss at, say, Rs 1050, he would have got stopped out the moment the price came down to Rs 1050 and his loss on the trade would have been limited to Rs 5,000.
There are innumerable such instances when stop loss has saved the day for countless traders and investors. Stop loss is a risk management mechanism that mitigates the risks of trading in the stock and commodities markets and saves the players from blowing up their account. Hence, a ‘stop loss’ is an absolute must for active traders and investors.