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"Never forget your stop loss" is a refrain that all traders hear right from day one. But it is like one of the lessons that one learns in kindergarten about not keeping your elbow on the table and not talking while eating. Everyone knows it but very few actually follow it.
The term ‘stop loss' is self-explanatory. It is an order that is punched in to the system or conveyed to the broker in order to limit the loss in any trade.
The stop loss level in case of a buy order would be slightly below the buy price, while the stop loss for a sell trade would be slightly above the short selling price.
The minute the stop loss level is hit, the order becomes a market order and the trade is terminated with a minimal loss.
Stop losses are essential for divorcing emotions from trading and are the key component of money and risk management strategies.
Willingness to take small losses with a smile is the hallmark of a good trader. Stop loss orders also come in handy to position traders who do not want to increase their blood pressures by watching the stock market ticker whole day long.
The stop loss order would ensure that the loss is limited in case the markets do a reverse swing. The reason why many dislike punching in stop orders is because prices have a tendency to move up to the stop loss level, trigger it, and then reverse and zoom upward.
This is more common when the stop loss levels are fixed near important technical levels. But these are hazards of the trade and must be borne with a shrug.
How deep should the stop loss be? The stop loss level will vary from one trader to another. It also depends on the trading style. For example, a swing trader would keep a deeper stop loss compared to a day traders.
A widely accepted norm is that the stop loss should typically be 2 per cent of the trading capital. That would mean that the trader would not be risking more than 2 per cent of his capital in one trade.
If a trader were willing to take a 2 per cent loss per trade, it would take fifty bad trades to wipe out his entire capital. So, it is a good idea to keep a monthly stop loss as well as a stop loss per trade. A monthly stop loss of 10 per cent is a good idea. If a loss of over 10 per cent is incurred in one month, it is best to stop trading. A holiday always comes in handy to calm down taut nerves and for re-working trading strategies.
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