To be a successful investor you must decide on your investment objectives, and then get a strategy that will work for you, and most importantly, establish rules for limiting your losses that you will adhere to. Don't leave it to chance or you'll be left with chump change. The importance of a Stop Loss can't be stressed enough. It is very simple. When you purchase, know exactly what your maximum potential loss will be.
Example of Stop Loss
Let's look at an example of a good Stop Loss. We'll use the axis bank chart and for the long-term investor who was using the 200 DMA as a signal to buy and sell. As I mentioned earlier, some investors use the crossing of the 200 DMA as a buy and sell signal. In this case, a sale would have been made when the axis fell below the 200 DMA at Rs.535. Then a purchase would be made at Rs.475 per share when Axis bank crossed back over the 200 DMA to the up-side.
The key to every trade or investment is to limit your potential loss. In this case, the purchase was made at 475 and even an 8% loss would have sold you out at Rs.439. Therefore, as soon as you made the purchase at 475, you should have entered a Stop Loss to sell your shares if the price dropped below, let's say 439. That way the maximum amount you would lose is Rs.38 per share. It wouldn't matter then if Axis bank crossing over to the positive side of the 200 DMA happened to be a false rally in the market and the price turned and fell back to its previous low of Rs.374, or even lower. You are protected and will not lose more than your set amount.
Don't be greedy or scared and enter a Stop Loss for only a few cents below your purchase. Every stock must have some breathing room and you don't want to get sold out senselessly. The 6% to 8% rule has been around for years. There is a reason this amount is used to Stop Losses. Meaning, normally if the price drops more than 6% to 8% then there is a valid reason for that much decline. And chances may be pretty good that it will drop further.
6.2 Trailing Stop Loss
In continuing our previous example, the wise investor re-purchased shares of axis after the bear market when it crossed the 200 DMA, and placed a trailing stop loss. A trailing stop loss is set to automatically move higher as the stock advances. It can be set to trail at any amount you choose, for instance, maybe Rs.30 below the current price. Thus, every time the stock moves higher, the stop-loss moves to stay Rs.30 below the price.
A trailing stop loss is a very good way to capture more profit and protect your investment money at all times. Using a trailing stop loss can capture more profit for you when used properly. By automatically moving higher as the stock advances it preserves most of your gain. Yes, you will occasionally be sold out and then have to wait for another entry point. But in the event there had been a Trailing Stop Loss in place as Axis Bank was advancing, then instead of selling out when Axis Bank fell under the 200 DMA, you would have been sold out at a higher price.
For instance, if you felt there was a correction in the market due to happen in the near future since Axis Bank was significantly higher than the moving average, you might have tightened up your trailing stop loss by setting it at Rs25 below the current price, then you would have benefited by capturing more of the gains and been out of the trade quicker.
As you can also see, there are many zigs and zags in the price as it advanced during 2016 and 2018. Yes, a stock can trade significantly above the 200 DMA for extended periods of time, but will eventually return to the moving average. In this case, a trailing stop loss would have worked well keeping it low enough to allow 'breathing room' yet higher than the 200 DMA to preserve as much gain as possible.
6.3 Two Important Things to Remember About Stop Loss
There are ONLY TWO things to remember about a Stop Loss.
USE IT! Without a Stop Loss, you are simply flirting with disaster, and sooner, rather than later, you will find it, or it will find you. When you enter into an investment, place your Stop Loss immediately. Always.
Don't Get Creative- A very good habit to form is this. If you place your trade online, then never get up from your computer after you enter your trade without placing your Stop Loss. The Stop Loss IS part of the trade. It is that important. Regardless, whether you are buying or selling short, a Stop Loss will not eliminate the risk. Risk is always there regardless. But common sense certainly tells us that a Stop Loss will 'Limit' the risk. That is what is important. Always place the odds in your favor.