Why should you always keep ‘Stop loss’, in trading…

This is yet another thread extract from @RajarshitaS. I blog for my own learning and immediate access, to revisit. Hope will be of value to you too..

What does not kill you makes you strong!!!

•Friedrich Nietzsche, the German philosopher, famously quoted in his book -Life’s school of war: “What does not kill me makes me stronger”.

This phrase has profound applicability in majority of the facets of life; depending upon how you react to the situation. My interpretation of the quote is –
(a) past experiences are the biggest learning
(b) Lose the battle but remain in War.

Words of legendary investor Ray Dalio’s sums up the ingredients of progress as follows –

Pain plus Reflection leads to Progress”. 

•Trading as sub-set of life also finds applicability of the above quote. Blowing up trading portfolio can be equated to getting killed in trading. Thus, risk management is the core of any investment/ trading methodology.

•In the earlier, threads, I had highlighted how any single trade can have any random outcome, irrespective of the quality of the trading system. Ace investor, Vijay kedia, sums-up the value of risk management system, discipline and patience as follows

Rome was not built in a day, but Hiroshima and Nagasaki were destroyed in a day”.

Do not let this happen to your weatlh

•As price changes in the stock market do not follow a normal statistical distribution pattern, probability of any single trade having severe adverse consequences on trading portfolio remains. This is where the role of stop-loss comes into picture.

The stop-loss and its role in trading

A stop-loss order is an order that automatically closes a losing position once the price hits the pre-specified level.

The types of stop losses trader’s uses are –

(a) Monetary stop loss – this is simplest of the stop loss, where trader fixed an amount loss bearable in the position.

(b) Technical setup based stop losses – traders use moving averages, support and resistance levels, swing highs and lows, Fibonacci retracements, trendlines and channels as technical inputs based stop losses.

(c) Trailing stop loss – Trailing stop loss is an stop loss for optimising the profits in a trade. As the trade, move in traders favour, the crucial levels based on price volumes activity volumes to a new zone.

Thus, trader raises the stop-loss level due in order to optimise the profitability via lower drawdown risk and keeping the upside potential intact.

(d) Volatility based stop loss – Market is ever changing and consequently the underlying volatility also changes.

Thus, the role of volatility based stop loss comes into picture. One of the most accepted parameter used here is ATR (average true range). A high ATR signals that past volatility is relatively high and trader would be required to keep higher stop-loss, which is x times the ATR.

(e) Time based stop loss- As the name suggest, time based stop loss calls for exit from a position if it fails to move in desired direction over said period of time.

This helps trader in optimal utilisation of capital and the strategy is particularly useful for the contra-trend traders (traders who trade fadeouts of the breakouts).

•Stop losses falls under two categories based on whether they are entered on to the system or exists in mind of the trader – hard stops and soft stops. Hard stops are the stops, which are fed in the system, while the soft stop-loss is the mental stop loss.

Hard stop loss reduces stress associated with the trade outcome and also closes the door on hope trading. Mental stops give the trader greater flexibility according to changing market conditions.

Mental stops should be used by traders with high precision having concentration ability and those having strict discipline.

Benefits of stop-loss

(a) Helps in capital protection and position sizing. If a trader enters a trade expecting it to be stopped out, she will naturally take moderate bets.

Moreover, use of volatility based stops, puts increased scrutiny over illiquid trade ideas. These factors together prevents the trading portfolio blowout.

(b) Resolve time bandwidth available with trader- Majority of beginner traders takes a trade early in the day and if the trade moves against them spends whole day watching the same.

Thus, they not only lose bigger than envisaged in the trade, but lose on the opportunity which arises during the day. Thus, one of the great advantages of the stops is that if frees you mentally and emotionally.

(c) Psychological benefits of putting a stop-loss – Putting a stop loss, helps a trader to overcome anchoring bias, usually expectation of the losing trade crossing over their entry price to exit in profit or cost to cost.

This is due to human mind-set, which weighs losses more than profits. Consequently, when we have a losing trade, we may try to avoid eventuality in anticipation of the hope.

•Thus, a stop loss not only helps in capital preservation, it also helps in multiple ways such as building discipline and bring great clarity by taking better risk reward trades, knowing the purpose of the trade, helps in handling mental issues of trading.

To sum up, stop-loss acts as the most successful tool in the kit of a trader to build his fortune.

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