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Importance of Stoploss Levels..

How often do you remember using a stop loss order on your trades ?? Even if your answer is 'never' , it will hardly surprise me because this is the most important aspect of trading in the stock markets which remains to be ignored by new traders and Investors.While the seasoned traders give utmost importance to it , the reason of which is explained here.

The term 'Stop Loss' order itself indicates the very purpose of it. Lets us take an example..

Suppose You have bought Stock X at 1000 for a target of 1200 or more.That places the profit potential at 20%.But what about the loss potential ..or exit strategy if in case the stock does not go up and starts crashing.The trade means you are ready to accept a profit of 200 rs per share on your trade but have not assumed of the condition in case the stock goes down.

For that purpose the Stop loss level comes in.The purpose is to define the maximum loss you are willing to take for a profit potential of rs 200 on a 1000 rs stock ,or the other way round the % ( percentage) of your money you are willing to risk to make a profit of 20%.You cannot and should not take unlimited risk for if the stock moves southwards you can face huge losses on your capital and along with it face blockage of capital.

Also to make you familiar with the process let us define the term risk/reward ratio.The Risk ( r )you are taking on your capital to make a profit or reward of (R) and to make continuous profits in the markets your r/R must be less than 1  given you can have a consistent accuracy of more than 50% in your trades.

                                               r/R ( risk/Reward ) < 1    

The reason can be explained with the stock X you bought for 1000 rs for 1200 rs target.Suppose you have a sell order for Stock x at 900 to stop your loss from getting bigger than 10% in case the stock starts falling.Now assume you do 10 such trades 5 times out of which the target is achieved and 5 times the stop loss gets hit.The accuracy stands at 50% and the total profit comes out to be :
                                      ( 200*5 - 100*5 ) = 100*5 = 500 

Thus in spite of taking 50% wrong decisions you end up with a profit of 500 rs or  50% on your capital from your trades.Now consider these cases.

Case 1) No stop loss : That makes your risk infinite for when some of the stocks when start to fall in bad times , never see their previous highs ever again.This can result in huge losses.

Case 2) risk/Reward=1 : i.e stop loss of 200 and a profit potential of 200 in the case of stock X.Thus after being 50% right and 50% wrong we end up making no profits.More accuracy would help in this case though.              

Case 3) risk /Reward < 1 : i.e bigger target and a smaller loss risk.These trade when made even with 50% accuracy can prove to be rewarding.

Case 4) risk/Reward > 1  ( stop loss greater than target ) : Taking such trades with big stop loss orders is not advisable.As only a few bad trades can result in a big loss.

All Above calculations apply only if you apply a stop loss order to your trades either long or short.Without stop loss orders surviving in the stock markets is near to impossible.Also another factor that plays a role in deciding about Stops is the time frame you are entering the markets. In case of investments and larger time frames exit options can be relaxed if you believe in the company and the future prospects.But in any case,being on the safe side doesn't hurt.


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