Stop loss Theory:
When we take a trading position or a delivery position, we always take it with an expectation of profit, which is obvious thing. But for some reason, if circumstances change, and our decision go wrong, we must have the ability to exit from such positions in time. And stop loss is a key factor that helps us do this.
Most of the time people initiate a trading position, short or long and after taking the position, they decide a stop loss. But very few persons act on what they decide. When market crashes suddenly due to panic, at that time they face decision paralysis. In such cases they watch helpless, and prices of their holdings plunge sharply in front of their eyes and they are not able to do anything and they incur big loss.
Types of Stop Losses:
- Primary Stop Loss
- Trailing Stop Loss
Most of the people know that they must follow strict stop loss, but very few people follow this rule. Some times what happens that in case of sudden panics, the prices fall sharply, and they rebound equally sharply, and so during the sharp decline, a stop loss is triggered. And later on the same stock rises back to the old levels, and again sharply after a stop loss being hit are very few, say 2 out of 10 times. So 2 times trader could get trapped in whipsaw, but the other 8 times, you are saved.
People need to understand their own thinking. Mostly once a position is taken and it starts declining more than expected, most traders hope that the prices will pull back a little, and then they will exit. But in most cases prices fail to pull back to the extent they expect, and prices keep on declining, and fear of the trader rises too. In such panic circumstances, most people lose their decision making power. That is why before We faces with such circumstances, we must follow the stop loss and exit the position in time. No one goes bankrupt by doing stop loss in time. But case of people losing their entire savings and property due to failed stop losses are sadly innumerable.
Benefits of Stop loss:
- Following stop loss upon trigger is like applying brakes to your car at right time. We are very well know that what will happen if we fail to apply breaks of our car at right time. Stop loss works like a parachute. When we plunge from heights, we have to open our parachute in time to safely come to the ground. If we wait more than a certain level, it becomes fatal. Same is with stop loss, if we do it in time, it saves us from further erosion which could be lethal for us.
Consequences of Not Applying Stop Loss and Trailing Stop Loss:
- Holding a declining stock without a stop loss is like riding a boat that is sinking. One has to jump from the boat at right time with the help of a ring or a lifeboat, so that we don’t drown with the boat. Stop loss is our life boat, or safety ring.
- When one fail to employ stop loss, their capital gets eroded before their eyes and they are not able to do anything.
- When one fail to employ trailing stop. Profits on capital get eroded, and we get back to square one.
What to do: First apply commonsense
- Innumerable real life examples like this can be given. In real life people follow the safety rules, but I don’t know what happens to their common sense when it comes to stock market.
- Big speculators are aware about this weakness of most of the traders and investors, so they take advantages of it. If people are not ready to acquire the necessary skills and knowledge, it is their problem and they are to be blamed.
- Market always gives at least one opportunity to everyone to save themselves and exit at right time. Seldom does market crashes without signals in advance. But as people don’t know how to take advantage of the signals, they fail to take timely actions.
- So instead of blaming others, we acquire the required skills and tackle such forces to our favor. As mentioned before even in case of fight, one must first acquire necessary skills to use the weapons, and have require armors with them if they want to survive and more importantly succeed.
- Many people does not follow the stop loss; thinking that it is a sign of weakness, and they think that by holding a losing position like that is a brave thing to do. But this proves to be a foolish thing to do in long run. Even in blue chip stock, if something goes wrong, one must have the ability to exit the stock in time and it is a wise thing to do. Only those people, who can act rationally, can win in stock market.
- Those people, who use the weapon of stop loss at right time, are always victorious in the markets in the long run.