Using stop-loss order for making a timely exit

Stop-loss orders are like health policies for stocks which come at zero premium. Besides reducing your losses, they also help you to lock in your profits.

   Krishna and Suresh had stated investing in stocks around the same time. After the recent fall in markets, both their portfolios took a hit. But the losses Krishna incurred were much less than those borne by Suresh. While Krishna had set stop losses for each of his stock, which he stuck to when markets corrected, Suresh kept on thinking that markets will rebound soon and that his stocks won’t fall beyond a point. The result: Krishna got a lesser painful exit from his investments, plus free cash which he invested in other value stocks. On the other hand, Suresh’s portfolio shed almost one-third in terms of value and he could still not exit as that would translate into serious losses, which may take years to recover.
   Talk to investors and we find thousands of such instances where people just ignored one basic principle of investing: Setting stop losses and sticking to it.

What is stop loss?

It is a pre-defined order to automatically sell a stock when it falls to a certain level. When the stock reaches the point, the stop-loss order becomes a market order and the trade is executed. It’s a very important investment tool, especially if you are typically trading in a bullish market situation, which helps to save the larger part of the pain in case the sentiment turns.

How it helps?

Stop loss is an important risk-management tool used to exit a stock before it falls any further. This not only helps in reducing your losses but also to lock in your profits. Consider you bought a stock sometime ago at Rs 100 and the stock is now trading at Rs 140. Now some negative news on the company follows bringing the stock to 120 levels. In this case, fixing an order at, say, Rs 130 may help retain a large part of the profit. It also comes handy when you go on a vacation or holiday and are not in a position to watch your investments regularly. Setting stop losses is all the more important for traders, who deal on a day-to-day basis and who have to generate returns with a limited pool of capital. Here, it helps to restrict their losses.

How to set a stop loss?

This depends on the way a particular stock behaves. If any stock fluctuates 4-5% in usual market situation, stop loss should not be fixed too close to it, or else the order will be triggered in day-to-day stock movement. Setting stop loss for a particular stock is an interplay of one’s risk-taking ability, the market situation and how that stock behaves. The idea here is setting a stop-loss percentage that allows it to fluctuate day to day while preventing as much downside risk as possible. And for investor who believes top losses need be adjusted from time to time, Stop losses have more to do with discipline, so I don’t think adjusting them from time to time is a good idea.

Bottom-line

Stop loss is a double-edged sword. It might be that one had bought fundamentally good stock but the price falls because of reasons other than fundamentals. So if the stop loss was fixed in that case too, the order would be triggered, which is not justified. Hence, stop losses are good for momentum buys and not for fundamentally good stocks. This tool is like health policies for your stocks which come at zero premium. It doesn’t require much to set it but rewards in return are plenty.