Investment education: What is stop loss, how to use it?

Many investors in the stock market dream of profit when they buy shares, but do not plan what to do in case of loss. This is why small losses turn into big losses. Investors who cannot sell a stock when it falls by 5% are sometimes forced to hold losses of up to 30-40%. An important strategy used to avoid such situations is the stop loss. A stop loss is a loss limit that is pre-set by the investor. Simply put, a plan that says, "If the stock goes below this price, I'll accept the loss and get out," is a stop loss plan. Its purpose is to prevent losses, not increase profits. Not all decisions are correct in the stock market, so a stop loss is necessary to prevent wrong decisions in time.

For example, you bought a share for Rs.500 per share. If you plan to take a maximum loss of only 10%, your stop loss can be Rs 450. If the stock falls to Rs 450, you can decide to sell as per your plan rather than just hoping that the “market will come back”. The first thing you need to do when using a stop loss is to understand your risk appetite. Not all investors should have the same percentage stop loss. A short-term trader can set a stop loss of 5 to 8 percent. Medium-term investors can keep a limit of 10 to 15 percent. But long-term investors can only decide if the company's fundamentals deteriorate, not just because the price has fallen.

While keeping a stop loss, you should also watch the fluctuations of the stock. Placing a very close stop loss on a highly volatile stock may result in the stock being sold during normal fluctuations. For example, if a stock is down 5-6 percent daily, a stop loss of 3 percent may be too close. Therefore, while placing a stop loss, the nature of the shares, trading volume and market conditions should also be considered. A simple way to use a stop loss is based on a percentage of the purchase price. If you buy a share at Rs 1,000 and decide to bear a maximum loss of 10 percent, the stop loss is Rs 900. If the stock starts to fall below 900 you can limit your losses and exit.

Another way is to place a stop loss based on the support price i.e. the support level. If a stock bounces back from around Rs 480 multiple times, then that area could be support. You can place the stop loss of the stock bought at Rs 500 just below Rs 480. But holding even after the support is broken can increase losses. Stop loss is useful not only for trading but also for investment discipline. After seeing the loss, many investors say, "What's the point of selling now?" But when the loss is small, it is easier to make a decision, when it is big, the mental pressure increases. Stop loss teaches you to act according to a plan rather than emotion.

But there is one common mistake when using a stop loss—placing a stop loss but not following it. Thinking about selling at a 10 percent loss before buying, but then saying "wait a little longer" when the stock goes down, stops the meaning of the stop loss. Stop loss only works if the investor sticks to his rules. Another mistake is to place the stop loss too close. Normal ups and downs are natural in the market. If the stop loss is too close, the stock is sold lower and may rise again later. So stop loss should be kept according to facts and plan, not out of fear.

When placing a stop loss, the investor must decide three things in advance. First, why am I buying this share? Second, what is my target price? Third, what is the price of proving my wrong decision? If the answers to these three questions are clear, then using stop loss is easy. In the market of Nepal, there are sometimes sharp fluctuations in shares, low turnover, circuit and liquidity problems. In such a situation, there may be a risk of not being able to sell at the desired price even if the stop loss is placed. Therefore, stop loss should be used more cautiously in low traded stocks.

Another use of stop loss is to protect profits. Let's say the stock you bought for Rs 500 has gone up to Rs 650. Now you can move stop loss around Rs 600 or 610, not Rs 450. This can be called trailing stop loss. This helps protect some profits from potential downside while keeping profits open. Using a stop loss is not panic selling. This is a practical strategy to control losses. Not that successful investors make a profit on every trade; They take small losses when they are wrong and let profits grow when they are right.

One of the biggest mistakes in the stock market is buying without a plan and holding on to hope. A stop loss minimizes this error. It reminds investors that before they can make money in the market, they must know how to save money.