The purpose of stop-loss

What the heck is a ''stop-loss''?
Quite simply, it is a way to limit your losses. The price of your stock can fall 30% after you buy it. But if you place your stop-loss at 10%, your loss is restricted to your stop-loss.

The purpose of stop-loss

In the stock market, there are only two things under our control:
1. Entry
2. Exit

What happens after our entry cannot be controlled by us. Also, once we make an entry we cannot undo it. The only thing we can now control is our EXIT. And that's where stop-loss comes in.

The purpose of stop-loss is two-fold:
a. Minimize losses
b. Maximize profits

Most people set their stop-loss based on their personal tolerance level. That is, they have a specific ''AMOUNT'' in mind that they can afford to lose.
Once they lose that much, they cannot take any more and close the position.

While this is not a smart way to set your stop-loss, it does save the average investor from further emotional pain and keeps them from losing too much of their hard-earned money.

Very often, this type of stop-loss proves to be ineffective.

Why does a stop-loss fail?
Two reasons:
a. Bad judgment
(You didn't set a logical stop-loss and reacted in an emotional way.)

b. Bad luck
(Let's face it. You can minimize losses, but you cannot totally eliminate them.)

What's a ''logical'' stop-loss?
Don't you hate it when a stock shoots up the moment you sell it?
When that happens repeatedly, most people conclude that a stop-loss doesn't work.

This type of thinking can lead to disastrous consequences. For instance, you might keep holding on to a loss-making stock till you're totally wiped out, or you might abandon a lot of potentially winning positions.

How to set your stop-loss

Smart traders set their stop-loss on the basis of certain patterns observed in the stock price (rather than arbitrary amounts or emotional conclusions)
There are many simple methods to set a stop-loss, which I will cover later.

An effective stop-loss will minimize your loss, while maximizing your chances of enjoying profits.
For example...If you are buying into a volatile stock, you cannot set your stop-loss at, say, 5%.Chances are, your stop-loss will be repeatedly triggered and you will end up getting in and out of a LOT of loss-making trades.

A 15-20% stop loss might be more effective for a highly volatile stock. That doesn't mean you have to be willing to lose more money. Instead, you can consider buying less. (Or, you can pick a less volatile counter.)