Since trading capital is the lifeline of every day trader, you must try to hold on to it by all means. The ideal way to do it is to know your entry/exit points. Stop loss orders as the name itself indicates are a risk management tool to limit losses on your portfolio if the prices tumble. By setting a stop loss you do not have to monitor the performance of your trades constantly. Thus, if you happen to be on a vacation or somewhere else you can rest easy for a while by using this tool. Stop loss orders are somewhat like a free insurance policy-in case a trade goes against your favour you will have your position automatically ended by your broker. There is no additional cost to be incurred for initiating a stop loss and your regular commission is levied once the stop loss price has been reached and the security/asset has been sold. Hence, all savvy investors must learn how to use proper stop loss placement techniques.
Stop losses are a two-edged sword: If not used judiciously they can demolish your portfolio in no time especially if you are a long-term value investor. It is important to keep few rules in mind while employing stop losses:
Never let emotions guide you:
Making investment decisions being led by emotion will inevitably land you in trouble. Like your initial stop loss your stop adjustments should be premeditated before initiating your trade. That way you will negate the risk of holding a losing position hoping that it will turn around at some point. Do not get into overtrading. Thus, you will be building discipline and learning to trust your stops and deal with losses just like gains (devoid of any emotions). However, do track your stop-loss strategy's outcome. Monitor how the assets fare after you sell them. If many of them rally, you should think about adjusting your stop-loss target.
Avoid a fixed target:
Rather than using a fixed stop-loss, use a target that assesses how an asset performs compared with the broader market while in your portfolio. It offsets a situation in which a steep market decline compels you to sell off because of temporary market conditions.
Trail your stop:
Trailing you stop implies steering it in the direction of a favourable trade. This locks in profits and controls your risk once you add more units to your open position.
Don’t broaden your stop:
Augmenting your stop only heightens your risk and the amount you will lose. If the market closes in your planned stop then your trade is initiated. Take the hit and proceed to the next chance. Widening your stop equates not having a stop at all. Always avoid widening your stop.
Don't go too low:
If you use a stop-loss that is very low, you will end up selling many of your assets even if their long-standing prospects remain quite robust. A stop-loss should be applied only to recognise potential losers that have significant momentum going against them.
While a stop-loss order is a simple tool, investors should use them sparingly and make the most of these order placements. Whether to limit excessive losses or to lock in profits, any investing approach can benefit from stop losses. A value investor's yardstick will vary from that of a growth investor, which will be unlike that of an active trader. Any one strategy may work, but only if you are consistent with the strategy. Be confident in your individual strategy and execute your plan. Stop-loss orders can help you stay on track by curbing your emotions. But stop-loss orders do not assure that you'll make money in the market; you have to make smart investment decisions anyways. Trade wisely and live to trade another day!
