The monster exposed
There are essentially three outcomes to exiting a trade. One, exiting at a profit. Two, exiting at a loss. The shades of grey lie in the third scenario where we consider exiting at a predefined profit, letting our profits run with a trailing stop loss and exiting at the stop loss level. It is in these areas that traders have the most problems.
Let's deal first with that nasty thingy called “loss”. Let us try and understand the nature of this monster.
Even God can't help you here
Wouldn't it be great if you did not have to ever take losses on your trades? Well, there is one person we know who never had to take a loss on the market at all. God. Unfortunately, we don't know how he does it. And we never will.
Oh yes! We did ask him, when we took a few phone calls from panicky traders a couple of weeks ago. Desperate souls with quavering voices and sweaty palms holding huge loss-making positions and not knowing what to do with them. (Have you ever heard a trader with a profit speak shakily?) At that point, we picked up the hotline to heaven and dialed the magic number. And the answer we got was always the same. It's too late.
God didn't tell us his fail-proof strategy. What he did instead was to give us lesser mortals a computer and the option of cutting our losses. So here we are, taking the circuitous route of covering the whys, whats and hows of “stop losses” in detail.
Some ugly truths about the stock market
Having decided to make a living trading equities, it would do us good to step back a little and look at the kind of animal we are dealing with: the stock market.
There is no way of predicting what the market will or will not react to or how it will react: From genuine earnings surprises to rumours of income tax raids on the big brokers, from the Nasdaq to the Prime Minister's knee problem, from FII buying to the overthrowing of the Fiji government, there is nothing that the market doesn't take a view on.
One of Murphy's laws is, “If anything can go wrong, it will.” This is one of the inescapable realities of life and markets. What's more, the market has the annoying habit of reacting to just about anything, anyway. More often than not, the market will react to events that have very little significance in the long run. But such events, which would be the tiniest blips in the scale of time, would have moved the markets sufficiently to wipe you out of home and hearth.
A trade made based on the strongest tip or the best research is just as likely to go wrong (or right) as the one picked by an anteater poring over the stock pages:
The market does have its own logic. A logic that is a messy amalgam of the opinions of trillions of people. You could try fundamentals, technicals, techno-fundamentals, financial astrology, tealeaf reading and tarot cards, but the market will do what it will. You would be a genius to be reading it right more often than not.
Losses are as integral a part of trading in equities as profits: Since markets are so unpredictable, you have to live with the truth that, just as sure as sunrise, there will be trades on which you will take losses. Like we said earlier, only God doesn't lose money on his trades. (Incidentally, we are of the firm belief that the good Lord is the greatest Punter of them all. He created the world, put man and woman in it and then went short on mankind. He is yet to cover his position. Looking at the mess we are in, it is unlikely that he will for a long time.)
Why a stop loss strategy at all?
What comes through from all this is just one thing: Markets are unpredictable and the only, repeat only, way to protect yourself against the market's unpredictability is to use stop losses.
Most importantly, if you wish to make a living out of trading on the stock markets, you cannot afford to lose large portions of money on every trade and still hope to stay in business for the long haul. The market has effortlessly emptied the deepest pockets, simply because there was no strategy to protect capital.
Look at it this way. Putting in a stop loss is not a sign of lack of conviction in your trade. It is a sign of lack of conviction in the mood of the market.
Trading is war
Try thinking of trading in equities as going to war and of every trade as an attack. It's okay to lose an occasional skirmish, but the objective is to win the battle. And that would be possible only if you, having aborted your attack, are able to come back again the next day and launch the next one. You have to stay in the game. You have to be alive to be able to come back and fight another day. And the only way you can be alivethe next day and not be a faceless statistic in the annals of history, is if you have a stop loss protecting your capital from major erosion.
Lose the battle but win the war
The stop loss is the point at which you decide that a particular attack has failed. The point at which you retreat from the battlefield with your capital intact, nurse your wounds, recuperate and watch the market for the next opportunity.
Without a strategy for cutting losses, you run the risk of losing so much on every trade that you are a financial and emotional disaster before the first week is over. You, in effect, martyr yourself trying to win the war of stock trading without arming yourself with a survival kit. They may declare a national holiday in your honour, but that is not going to do your bank balance any good.
ZZZZZZ...
OK. We have now come to a point when we realise that if we go any further we run the risk of you falling asleep at your terminals. You have taken a peek at the dark side of the market and understood why you need a stop loss to protect yourself from the market's mood swings. Now pick up Sharekhan’s Smart Charts, which presents the best positional trading calls in the market today. Each call is introduced along with a recommendation (Go Long/Go Short), a price target, a stop loss and a chart depicting the trend in the stock. Log in to your trading account with Sharekhan now and start trading. Check the monthly performance of Smart Charts here. If day trading is what excites you, take your pick from Sharekhan’s Day Trader’s HIT List now
