Best Stock Trading Book

 

Profit From Prices

A book on stock market trading
By Jayesh Patel, CFA

Chapter 4

STOP-LOSS: HOW TO USE IT IN TRADING

Chapter Outline:

1. INTRODUCTION TO STOP-LOSS
2. COST AND BENEFIT OF USING STOP-LOSS
3. HOW TO EFFECTIVELY USE STOP-LOSS
4. PROGRESSIVE STOP-LOSS

(one unsolicited opinion about this page.) Hi, I am an investor who is trying to protect some profitable trades. In doing so I was looking for a method of setting STOP LOSSES on my stocks. I found your write-up to be excellent. It was very helpful in understanding the method of setting a Stop Loss for a stock. Most write-ups describe why a Stop Loss should be set but never explain how to determine where to set the stop. This is a THANK YOU for your excellent explanation. Regards, Phil Lenkevich

 

One important dimension of any trading system is the ability to keep losses small. This is most of the times achieved with the use of STOP-LOSS. So let us spend some time to learn what a Stop-loss is and how one can use it in trading to his advantage.

Stop-loss is a widely used term in investment circles. As the name says, it is a price level at which one should stop or limit his losses in a position. Investing or trading is like gambling when one looks at from the outcome perspective. When a person gambles or speculates, he does not know what the outcome will be. He would hope the outcome to be in his favor but it could very well go against him. The same thing goes for investing or trading. When someone buys a stock, he might be thinking, and to a great extent hoping, that the stock price would go up, but it could very well go down. So what should a person do if the prices go contrary to one's expectations?

There are two alternatives: (i) He can continue to hold it believing, and hoping, that it will ultimately go up; or (ii) He can blame the unexpected mess on his wrong selection, bad judgment, bad timing or on circumstances/development beyond his control or imagination, and… get out of the position.

INTRODUCTION TO STOP-LOSS

It is a price level or a mechanism that forces a trader to take/book losses in a losing position instead of letting them grow any bigger. Ideally a Stop-loss level should be decided as soon as a trade is executed. If a stock say ABC is bought at 25$, Stop-loss for it can be kept at a price level somewhat lower than 25$. It can be 24, 23, 20 or even 15$. Let us assume the Stop-loss is kept at 20$. This means if the price of ABC, after having bought at 25$, goes below 20$, one should close the position by selling it. 5$ is the loss the buyer is limiting to. This might be little confusing for novice traders because it involves closing a position willingly at a loss! Remember: In a long position, the Stop-loss level is usually lower than the entry price.

Likewise if a person Shorts (what is this term? It means sell first even if you don't own the stock with the hope to buy it back later at a lower price) ABC stocks at 25$, he should keep a Stop-loss at any price higher than 25$. Say if it was kept at 30$, this means if the price moves up contrary to the initial expectations of it going down, and touches 30$, one should call it a quit and square up the position. Thus, in a short sell, the Stop-loss price is higher than the price at which the stock was sold.

 

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