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Wednesday, December 27, 2006

Stock Market Trading - Stop Loss, what to do

A "Stop" is termed as an instruction to stop out of a stock when it reaches the stop price. In case you are long, then a stop price would be the one that you would want to sell your stock for and would not want to hold it, if it goes below that price. Let us consider an example.

Stock "ABC" is currently trading at Rs.125. You bought it at Rs.120. After lot of analysis and/or your own gut feelings/thoughts you decided that you wouldn't want to hold this stock if it goes below Rs.123. This is where you instruct your broker to sell the stock. This is known to as a "stop loss at Rs.123".

How do you determine what stop loss to use. There are many ways to do this, but there are the two most common ways.

Place a stop at the low of previous day or just around that price.
Place a stop at the low of current wave. If the stock is too far from the low, then this is not applicable. But if the stock is relatively near the low, you can use this method. For example.

Stock "DEF" has had a rough down week and it started recovering on say Thursday. This day, the low was Rs.95. You got in around Rs.102 on Monday. You have an option of choosing the previous day's low, which is Fridays low, or the lowest low before the stock started to climb up, which is Rs.95.

Who should use a Stop Loss. Generally speaking a person who has a long term horizon, anywhere from 3 months to years, should not use this. Because if you have such a long term horizon, you must have done some sort of a research and only then you must have invested. And small fluctuations should not deter you from pulling the plug. Stop loss is primarily for Short term and especially Day-traders.

Is there a fool proof way to get to stop loss price. The answer, unfortunately is NO. Some ways work on one day and the other they don't. One must take into account a lot of factors before they place a stop loss or even when they decide to sell a stock.

The current trend.
Moving averages. Especially 50 and 200 DMA/EMA.
Major Support and Resistance levels.

The average price range of a stock. Price range is the difference of high and low of a stock on a given day. If a stock is predictable then it should generally honor the price range, unless there is some good or bad news.

Volume is another key factor. Never get sucked into the false rallies or false breakdowns.
At times Fibonacci numbers also assist a lot.
Whole numbers. Rs.100, 200, 150 etc. These also have a lot of impact on a stock. Having said so, it doesn't mean or convey that you Must look at all of the above factors before selling. But what we are trying to say here is, you must have a close eye on all of these numbers. Because all of these are very Key and important numbers.

Should i be using a Stop Loss. One of the key things to remember when using stop loss is that if you "place" your stop loss order then it is visible to the Market makers and they do play good games. From our experiences we can tell that most of the times Market makers move the stock price just to pick up your shares only to move the stock back up. This is a very old and still prominently used method. Thus, we would advise using Stop loss with a lot of caution. Better yet, if you can place a "Mental stop loss". Mental stop loss is the one where in you do not actually place a call to your broker(or online) to use a price as stop loss, but instead just keep a close eye on the stock movement and decide to sell it if the stock falls below your mental stop loss price.

Benefits. One of the main benefits that you get out of a stop loss is, stopping the loss. If you do not have a stop loss and a stock is falling like a rock, then you may never get a chance to sell it for a better price. But with a proper money money management and stop loss mechanism, you can avoid huge losses. Which otherwise wouldn't be easy.

So to conclude, Stop loss is a useful handy tool to control your losses. But at the same time there are some disadvantages associated with it and you must take them into account as well.

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