Importance of Setting Stop Losses
Previously we got a brief idea of how a stop loss can be used to avoid some common trading mistakes. Therefore, in this unit, we will focus more on the importance of stop-loss while trading.
Setting stop loss is a mental tactic which enables you to preserve your capital and prolongs your stint in the stock market. So, invariably, the importance of setting stop losses is directly proportional to the importance of preserving one’s capital.
Let us enumerate this concept with the help of basic mathematics.
Suppose, you start trading with ₹100.
Within a short span of time, you lose ₹10.
As you can see from the table above, as the % of loss on capital increases, it keeps getting tougher to be able to restore it to its original value. When we lose 50% of our money, we need to double our investment (100% gains) to be able to reach the stage from where we started.
A. Risk-Reward Ratio
Ideal risk-reward ratio should be 1:3 which means that if positive price movement is by 15% i.e., gains or reward for you then your stop loss should be at 5% price movement on the opposite side. Hence, your losses should be on average one-third of your gains.
B. Trailing Stop Losses
Trailing stop losses is when you continuously change the level of your stop loss based on what is happening in the market. Basically, when the price moves in favour of your bullish trade, you keep increasing your stop loss level keeping the % of loss on capital constant. Similarly, you keep decreasing your stop loss price level in the case of favourable price movements on a bearish trade.
C. Different Stop Losses for Different Trading Strategies
Different trading styles attract different risks, hence we have to have different stop loss levels for them. We can’t have one single strategy for all our trading styles. There is more risk in day trading so stop losses should be set at 0.5-1% of your invested capital, as all trades are time bound.
In case of swing trading, one holds the stocks for several days to a few weeks in order to gain from price movements or swings. Since the stocks are exposed to overnight risks, the stop loss should take into account the volatility of the stock. Stop loss can be set at 5% level.
In case of investments (which typically have a holding period of minimum 6 months), the strategy used for investments is mainly fundamental analysis. It ensures that one is investing in a solid business which will be less affected by the ongoings of the world in the long term. Based on how good a business you are investing in; your stop losses can vary from 10-20%.
D. Heuristics for Setting Stop Losses
- Swing Low/Swing High: When you take a bullish position on a stock, your stop loss can be just below the swing low. Swing low is when the price is lower than any of the lows in a defined trading period. Similarly, when you take a bearish position on a stock, your stop loss can be the swing high. This obviously has to be seen relative to your probable loss in capital percentage but it can be used as a general guideline as swing low and swing high are those levels from which the stock had earlier bounced back in the opposite direction.
- Technical Indicators: There are few technical indicators which help in identifying and putting appropriate stop losses. They give us the exit at the right time hence saving capital. Average True Range and Parabolic Stop and Reverse, super trend, moving average are few commonly used technical indicators to put initial or trailing stop losses. ATR is a volatility indicator and is often used to determine trailing stop losses. PSAR is a trend indicator which shows whether the current trend is likely to prevail or reverse. One can move the stop loss to match the indicator at every price level, thus this indicator also helps in setting trailing stop losses. Moving Average and Supertrend also help to do the same.