This was the headline on moneycontrol.com on Monday, the 21st Jan 2008. It also had the following information about the biggest losers that day:

Now suppose you had invested all your savings in some of the stocks listed above. You might lose your faith in stock markets on witnessing a more than 30% erosion of your wealth. And it could have been worse than this!

Stop loss orders are often used by traders and investors as a risk management tool to limit their downside risk.

With a stop loss order in place, an investor doesn’t have to actively monitor the markets and his portfolio. Recently, we have witnessed some major corrections and downward spikes in the market. Sometimes Nifty and Sensex fall more than 10% in a single day and certain so-called blue chip stocks plunge by more than 30% in a single day. So in such a scenario, any risk averse investor would like to define the maximum loss that he can bear.

The most commonly used stop loss orders are:

 This order is given along with a buy order to limit losses in case the price fall below a certain point. For example, if I buy TCS shares for Rs. 850 and I am worried that it may fall drastically beyond Rs. 800, I can place a sell stop loss order at Rs. 800. If the price of TCS drops to Rs 800, the sell stop order would be activated as a market sell order (the TCS share would be sold instantly at the highest price available). So, I have limited my losses to Rs. 50 per share only.

This order is placed when we go short on a stock and fear that the prices may go up. Now, lets take the same example of TCS shares currently trading at Rs. 850. My bet is that TCS shares are highly overpriced and they are going to fall in short term. But I also fear that a bullish market rally can push the stock to higher levels once its crosses Rs. 900. So I would place a buy stop loss order of Rs. 900 and if the price rises to Rs. 900, the buy order would get activated as a normal market buy order (TCS shares would be bought instantly at the lowest price available)

This is a very interesting and useful technique to protect your profits. Taking the same example, I buy TCS shares for Rs. 850 today and after 2 months they are trading at Rs. 1100 giving me profit of Rs. 250 per share. I already have Rs. 250 as unrealised profit. Now I fear that this bullish run might be coming to an end and I would set up the trailing stop loss as 10%. This means that my broker would sell off the shares once the price drops to Rs. 990. The trick is to set the percentage level and the price level to book maximum profits.

The best traders understand that they can’t be right every time and thus they get out of the positions once they know that their bet is going wrong.

I shall substantiate this argument with an example. Let us suppose that I enter into 100 buy trades this year. Now for every trade assume that I have a view that these stocks are going to give 20% profit. Suppose I have a very hard luck during this year, and only 50% of my bets go right. I have entered 2% as my stop loss order for all the stocks. So, by simple arithmetic I can say that I have finally made a profit of (50*20 – 50*2)/100 = 9%. Wow, I am getting 9% returns though only 50% of the total bets went in my favour. Similarly, I would get 6.8% returns for 40% of the bets in my favour and 11.2% if 60% bets go right.

Now that I have advocated the practice of placing stop loss orders so much, I would also talk about the viewpoint of critics of stop loss orders. The critics comprise mainly of long term, fundamentally oriented investors who believe in absolute valuations. They believe that once we have established a fair value for the scrip, there is no point in exiting because of short term price fluctuations. In fact when the price drops, it should be a considered as a buying opportunity.

Stop loss orders are also known to cause market crashes. Given that there are millions of stop losses for the TCS shares ranging from Rs. 800-750, there would be a massive selling pressure (millions of sell orders) and because of this huge gap between demand and supply, TCS shares would plunge further.

There are various ways in which traders and investors establish their stop loss orders. Some use the percentage model where the shares are allowed to retrace a certain percentage of the buy/sell price before the square off. Day traders use support and resistance levels to determine stop loss points. For example in case of a buy order, sell stop order can be placed at the support level as the stock price is expected to fall drastically if it breaches the support price. Similarly in case of sell order, buy stop loss order can be placed at the resistance price as the stock price is expected to rise sharply after crossing the resistance. Others determine stop loss points using volatility based measures like ATR (Average True Range) or fundamental measures like P/E ratio etc.

Submitted by: Rajjeet Kadian

www.moneycontrol.com

www.nseindia.com