What is Stop Loss in Share Market? Its Importance In Trading?

The feeling of bewilderment is common among people who are new to the stock market. There are just so many things to know and learn that it is quite easy to lose track of what is important and what is not.There are a few things that you should definitely know before you place your first trade, and then there are things you can learn along your trading journey. One thing that you should understand as thoroughly as possible is ‘stop loss’. You might have heard or read time and again that you should always use stop loss while trading. What is stop loss ? Is it necessary to use stop loss for every trade you take? Here is the detailed explanation-

As the term suggests, 'stop-loss' is a method of stopping your losses. The majority of the people who are opening their trading accounts now look at the stock market to generate additional income. In other words, most of the beginners have full-time jobs or businesses to take care of.Unlike full-time traders, most new traders don't have the time to sit in front of their trading screen throughout the market hours. This makes stop loss all the more important. Let us try to understand stop loss with the help of an example-Let us assume that you purchase 100 shares of X company at Rs. 300, as you believe that the price will go up. You will earn profits when the price of X moves above Rs. 300. But what if the trade doesn't work out as expected? What if X's share price starts falling after you make the purchase and are not present on the trading screen?This is where you can use a stop loss for limiting your losses. The stop loss allows you to fix a level or price at which you'd like to exit the trade if it doesn't work out as expected. In this case, you can place your stop loss at Rs. 298. If the share price of X starts falling, your position will be automatically squared off at Rs. 298, thus minimising your losses.

There are many different ways in which you can place a stop loss. Some of the stockbrokers in India now allow traders to place a separate stop-loss order. Alternatively, once you have taken a position, you can always place a ‘SL’ or 'SL-M’ order to place your stop loss.With the SL order, you will be required to enter a ‘Price’ as well as a ‘Trigger Price’ at which your buy/sell order will be activated. With SL-M order,  the ‘Trigger Price’ will be the price at which your stop-loss order will be activated. There are now other types of orders such as ‘BO’ (Bracket Order) and ‘CO’ (Cover Order) where you can enter stop loss right when placing your trade.

The stop loss selection strategy varies between stocks and traders. For instance, a stock that is trading at Rs. 2,000 generally fluctuates by Rs.20-30 daily. But a stock that is trading around Rs. 300 will mostly give a movement of Rs. 4-5 on average. So, you cannot select a fixed amount, such as Rs. 5, as your stop loss for all the stocks.Similarly, the risk management and trading style of every trader varies too. For instance, a trader with more capital might be capable of taking bigger losses than another trader with a smaller capital.

Even though there are no set rules for selecting stop loss, here are a few tips that can help you create your own stop-loss strategy-

• Focus on Percentage and Not Rupees Stop Loss Rather than considering the price movements in rupees, get in the habit of tracking markets in terms of percentage. For instance, while a Rs. 5 stop loss might not be the best choice for every stock, you can use a 2% or 3% stop loss.So, for a stock trading at Rs. 2,000, the stop loss can be of Rs. 40, and the same for a stock trading at Rs. 300 will be Rs. 6 if you consider your stop loss at 2%.
• Track Resistance and Support Professional analysts track support and resistance of stocks and indices for placing their stop loss. A support level, also known as demand zone, is a price level at which buyers are generally activated. A resistance level, also known as supply level, is a price point where people place their sell orders.So, for instance, if you have purchased a stock, you can place your stop loss somewhere close to the support level of the stock.
• Focus on Your Capital and Risk Management Some traders are aggressive, while others are conservative. Some can hold their position even when their P/L shows significant losses, while others might want to exit as soon as their P/L turns red. So, to create your stop-loss strategy, ensure that you focus on your risk management and capital.If a friend of yours is comfortable with taking a 5% loss on trades, this doesn’t mean that a 5% stop loss is the right strategy for you as well.

Trailing stop loss is generally used for preserving your profits. Some brokers now allow you to enter trailing stop loss in percentage or rupees. With others, you will have to trail the stop loss manually. Here is how it works-Let us consider that you have purchased 100 shares of a big company Y at Rs. 2,000 as you are bullish on the stock. Your analysis was right, and the price has now reached Rs. 2,020. Now, you don't want to exit your position as you believe that the price will rise further. But at the same time, you don't want to lose your profits.In this scenario, you can use a Rs. 5 trailing stop loss. With this, your stop loss will be placed at Rs. 2,015 as the current share price of Y is Rs. 2,020, and your trailing stop loss is Rs. 5. As the share price of Y will reach Rs. 2,025, your trailing stop loss will be shifted to Rs. 2,020.If at all the price of reliance starts falling after reaching Rs. 2,025, your position will be automatically squared-off at Rs. 2,020 for preserving your profits.

Now that you know what is stop loss , it shouldn’t be difficult for you to understand how it can help you limit your losses, especially if you are not a full-time trader. It ensures that your position will be squared-off automatically if it reaches a certain level selected by you.Know that even most seasoned traders and analysts use stop loss in each of their trades. There is no reason why you shouldn’t be using them. If you are serious about trading and want to earn consistent profits, stop loss should definitely be a part of your trading setup.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.