Among many risk management techniques available to traders and investors, stop loss is one of the easiest concepts to understand and apply but you need to know how to calcuate stop loss. Stop loss is an order that is set by a trader or investor instructing the trading software to sell the security if the security hits a specific price. This is done to minimise the losses if the price moves against your expectation in the opposite direction. In simple words, you are trying to stop your losses from increasing.

Benefits of stop loss

The main reason to put a stop loss order is to minimize any downside risk and protect your capital. Markets are uncertain as there are many factors that affect the prices. So to protect your money from any adverse market reaction, you must have a stop loss order for every open position.

If you are a trader, you will know every trader goes through a lot of emotions and they tend to make the wrong decision in those instances. So to avoid any bad decisions due to emotions, it is imperative to put a stop loss order and if you use a stop loss order there is no need for constantly tracking any probable downside.

By using a stop loss order, a trader can decide beforehand how much money he/she is willing to risk or lose in a trade. This is prudence when trading or investing and you can protect the total capital from heavy losses.

Your stop loss order need not be fixed, it can be dynamic. Some traders and investors use trailing stop loss where the stop loss gets adjusted as the price moves. It helps the trader or investor to book profits and reduce losses. If you have taken a long position, and your stop loss is 2% and the current market price (CMP) is Rs 100, then the stop loss is Rs 98. If the CMP moves to Rs 150, then the new stop loss will be Rs 147 per share.

Different ways of calculating stop loss

Moving average method

Moving averages are among the easiest ways to use stop loss and it is also easy to interpret. This is because moving average is readily available as a technical indicator and you do not have to calculate manually. If you are a trader or investor and have taken a long position, then when the price of a security falls below 50 MA or 100 MA you sell the security. On the other hand, if you have taken a short position and the price of a security rises above 50 MA or 100 MA, you square off your position. The most commonly used moving average method is simple moving average (SMA) and exponential moving average (EMA).

Support and Resistance method

Another method for finding out the stop loss is determining the support and resistance zones on the technical chart. To use this method, you should have a good grasp of interpreting the technical charts, price movements and a keen eye to spot the areas where the price is reversing. This method is not suitable for beginners and it needs some practice to become good at it. So if you have a long position, the stop loss will be below the support area and if you have a short position, then the stop loss will be above the resistance.

Percentage method

In this method, you calculate the stop loss as a percentage of the entry price or buy price. As a prudent risk management practice you are not supposed to risk more than 2% of the buy price. So if buy a share for Rs 400, then you should put your stop loss at 392 (400-(400*2%)). So when the share price moves against your prediction and when the price hits the stop loss of Rs 392, the shares will be sold automatically. By doing so, you will save capital and have the capital to go for the next trade and seize a new opportunity. You will not be broke and out of the market.

Conclusion

Using stop loss is very important to any investor or trader as it helps them to reduce losses during volatile markets or adverse situations. This leads to preserving your capital and helps you look out for the next opportunity. Knowing to use a stop loss will make a significant difference in terms of surviving the market and your success in it.