Importance of maintaining Stop Loss

Introduction
Traders before trading or investing in stocks always identify whether the stocks are undervalued or overvalued. For identifying this undervaluation or overvaluation of stocks, traders assign a price target to the stocks and compare its current price with the price target. If the target price is greater than the current price than the stock is considered as undervalued and the traders buy the stock in the hope that the target price will be reached in the future.

Though it is perfectly correct to assign target price to the stock before investing, in true sense it creates a bias. The price of a stock can go either ways- up or down.Here, it is accounting for movement on upside and not accounting for downside.

Undervaluation does not imply that the stock cannot go down; in the past there have been many instances when stocks have continued to decline for longer periods of time. Thus, as it is important to have a price target on the upside it is also very important to have a price target on the downside,which indicates the loss bearing capacity.Placing limits on the downside is most commonly referred as "STOP LOSS".

What is a Stop Loss?
A stop loss is the point or price beyond which if the current price of the stock goes, then you reverse your earlier position. A stop loss order instructs your broker to sell when the price hits a certain point or price. The purpose of stop loss is that you want to get out of the stock before it falls any further and it indicates maximum loss you are willing to absorb.

How does it Work?
If you use an online trading platform, you can set a stop loss yourself. Otherwise, you may ask your broker to maintain a stop loss order at a certain price on the stock. When, and if, the stock hits that price, your stop loss order will become a market order, which means your stock will be sold at the best market price available immediately and will limit your losses.

Illustration
Suppose you have bought one stock ABC ltd. at Rs100Rs. for a target of 120 or more. This places the profit potential at 20%.But what about the loss potential or the exit strategy?The above trade means you are ready to accept a profit of Rs20 per share on your trade but have not assumed of the condition in case the stock goes down.

The purpose of the stop loss is to define the maximum loss you are willing to take for a profit potential of Rs20 Rs. on aRs100 stock in this case. So for example if you have assigned a stop loss of Rs90, then it suggests that you are willing to lose not more than Rs10 or 10% on aRs100 stock. Now if the stock moves down you will not lose more than Rs10 per stock and this puts a limitation on your downside.

Why stop loss is important?
It is a general tendency for traders to sell the profitable shares quickly and to hold on to the losing stocks for a longer period of time in the hope that in future they will bounce back. This bias in behavioral finance is termed as "fear of loss". Traders generally fear loses and don't sell the stocks if the prices go down. This, in adverse market conditions, can create huge losses as there is no limitations on loses. Thus it is always advisable to have a stop loss to restrict loses or to limit the downside.

How to set stop loss targets?
While most traders understand that it is important to apply stop loss to all their positions, they often don't know how to arrive at stop loss targets. The most common doubts which they have before setting up stop loss targets are:

• How to arrive at stop loss target?
• Should the stop loss be quite close to the price or little wide?
• Whether the stop loss should be trailing which keeps on changing with price?

Below are some of the factors which will help in deciding the stop loss strategy:

1. The most important factor that affects stop loss strategy is the question of how much you're willing to lose on a single trade. Some say that 2%is an ideal stop loss. Yet this can be tempered by other stop loss strategy considerations, such as how much money you have in the position. If you have a large amount of money in a position, 2% may be much more than your willingness to lose. If so, you should set stop loss strategy accordingly. However, if your account is small and you're not well diversified, a 2% stop may be so tight that you stop out of the position almost immediately. If this is the case, you should think seriously about whether you have enough money to trade.
2. Another stop loss strategy to take into account is how risky you believe the trade to be. If you think the trade is a sure winner and market conditions are favorable, you may give the position more room to move. But if you think it's got only a fair chance of working out, or if the position has serious potential to drop, set a tight stop loss strategy.
3. It is also important to consider how volatile the position is. If the position routinely moves up and down in a range of 15% or more over the course of the day, you can't set tight stop loss strategy. If you do, you'll be taken out by the position's normal volatility. If the position is choppy but too risky to trade without tight stop loss strategy, you'd better look for a better position to trade. If you have reason to be confident that the position will move upward even if it swings around a bit first, it doesn't make sense to set a tight stop loss strategy because you'll just stop out as it swings. However, if you think it might possibly move up but will definitely drop if it slips below a certain price, then tight stop loss strategy is a must.
4. Market conditions should always be an important part of your decision. If the market is trending sharply upwards, tight stops may not be necessary. If you're trying to go long in a bearish market, tight stops are absolutely necessary. If the market is choppy that is if it has no clear direction or if it's full of nervousness and fear, then use tight stop loss strategy.

Since no two trades are the same, different factors will dominate on different trades. Think about all of them on every trade. If you don't, you'll miss something important. Setting stop loss strategy is an "art". You will have to experiment a bit and learn what works for you. Occasionally you may stop out of a trade too soon and feel frustrated, but remember this is just like paying for insurance.

Sometimes you'll be stopped out, but other times, you will save your capital. Over time, you'll get better at setting stop loss strategy. Eventually, you will be able to have a sense of each trade, and set the stop loss strategy that work best for you.

Conclusion
Stop loss orders work like insurance policies that cost you nothing but if your call on the market goes wrong then they can save a fortune. If you are not willing to hold on to the stock forever, then it is always advisable to have a stop loss to limit your losses in case the price of the stock moves opposed to your predictions.