The investors or traders before trading or investing in stocks always identify whether the stocks are undervalued or overvalued. Traders assign a price target to the stocks and compare its current price with the price target. When the target price is greater than the current price than the stock is considered as undervalued and the traders buy the stock in the hope that the target price will be reached in the future. Although it is perfectly correct to assign target price to the stock before investing, in true sense it creates a bias. Stock price can go either ways- up or down. So it accounts for movement on upside and not for downside. Analyzing market technically is very important to generate accurate trading tips.
Let us understand what is a Stop Loss?
Stop loss is the point or price beyond which if the current price of the stock goes, then you reverse your earlier position. You must remember that a stop loss order instructs your broker to sell when the price hits a certain point or price. Objective of stop loss is that you want to get out of the stock before it falls any further and it indicates maximum loss you are willing to absorb.
Working of Stop Loss
When you use an online trading platform, you can set a stop loss yourself. Or else, you may ask your broker to maintain a stop loss order at a certain price on the stock. When the stock hits that price that your stop loss order will become a market order, which means your stock will be sold at the best market price available immediately and will limit your losses.
Importance of Stop Loss
Generally, traders sell the profitable shares quickly and to hold on to the losing stocks for a longer period of time in the hope that in future they will bounce back. It bias in behavioral finance is termed as “fear of loss”. The technical traders generally fear loses and don’t sell the stocks if the prices go down. In adverse market conditions, this can create huge losses as there is no limitations on loses. Therefore it is always advisable to have a stop loss to restrict loses or to limit the downside.
As we know that no two trades are the same, different factors will dominate on different trades. You need to think about all of them on every trade. When you do not, you will miss something important. Setting stop loss strategy is an “art”. You will have to experiment a bit and learn what works for you. Infrequently you may stop out of a trade too soon and feel frustrated, but remember this is just like paying for insurance.
From time to time you will be stopped out, but other times, you will save your capital. Over time, you’ll get better at setting stop loss strategy. Ultimately, you will be able to have a sense of each trade, and set the stop loss strategy that work best for you.
The Stop loss orders work like insurance policies that cost you nothing but if your call on the market goes wrong then they can save a fortune. When you are not willing to hold on to the stock forever, then it is always advisable to have a stop loss to limit your losses. Thus to win in trade, it is important to use stop loss strictly.