Stocks – Lesson 4

Stop the Losses (When to Sell – Part 1)

In lesson 3 we just learnt that the most important thing to do in investing in Stock Market is to take care of the losses. Make sure your losses are minimum and how do we do that. One technique that we learned was not to make big bets. The rule that you are going to learn is the most important and should be adhered with a lot of discipline.

Let us take the same example of the previous lesson. You got 1 lakh to invest in stocks and 5% of that you use to get 14 shares of Wipro at 371 Rs per share. So you have now invested 14 * 371 = 5194 Rs (i.e around 5% of 1 lakh). The next day you look at the price and Oh my God !! Wipro is quoted at 300 Rs, a fall of 71Rs per share taking your paper loss to 994 Rs. Not bad you think , after all it is WIPRO, it has posted great profits so it will come up. The week after that Wipro is at 200 Rs. Now your paper loss stands at (371-200) * 14 = 2394 Rs. What do you do? Many people hold on to their stock with the belief that it will come good one day. It might, but there is a possiblity that ‘THE DAY MIGHT NEVER COME’. So what is the best you can do?

Stop Loss Orders are the answer. When you buy Wipro or any Stock for that matter, make sure you place a stop loss order at some fixed % below the purchase price. The % depends on your choice but make sure that it is not more that 25%. (Ideally 10-15%). What will happen is that when Wipro’s share price falls below the indicated stop loss price, the stop loss order gets executed and your shares are sold ensuring minimum loss to you. Should I place the order for all the shares I bought? No.. Don’t do that too. Sell half or 2/3 of the shares (7 shares or 10 shares of Wipro in our example). Place another stop loss a bit further down from the earlier one where you will sell another % of shares. But the final level at which you sell all the shares should not be greater that 25% of the initial value. Too Confusing !! Right? Let me explain it in simple terms.

    * I go and buy 14 shares of Wipro at 371 Rs. Fine.
    * At the same time I place a stop loss order to sell 7 shares of Wipro if the price falls to/below 316 Rs.  [7 shares is 50% of 14 shares. Rs 316 is 15% less that Rs 371]
    * I place another stop loss order to sell 4 shares of Wipro if the price falls to/below 297 Rs [4 shares of Wipro is close to 25%. 297 Rs is 20% less than that of of Rs 371]
    * I place yet another stop loss order to sell the remaining 3 shares of Wipro if the price falls to/below Rs 278 [3 share of Wipro is close to 25% and 278 Rs is 25% lesser of Rs 371]

What I have done is ensured that my loss at the maximum will be 7*(371-316)+4*(371-297)+3 (371-278) = 960 Rs (i.e 7*55 + 4*74 + 3*93 = 385+296+279). Great. At the worst scenario our total loss in the trade would be 960 Rs + Agent’s comission. That is just fine. But how does the entire process of stop loss order takes place.
We place the stop loss order using our broker (person, by phone or through internet). Once the price of the stock for which we placed the stop loss order reaches or falls below the price that we indicated in the order then the order gets executed and the shares mentioned in the order or sold to the market at the current rate. This is known by the term that we have been stopped out. The same happens for the subsequent orders. It might also happen that Wipro might fall to 316, stopping us out of the first order and continue to fall till 300, but then it might climb back to 450 (who knows what might happen), in that case we would have sold 7 shares at 316 but we still have 7 more shares and with the price at 450 it means that we now have a profit of (450-371)*7 = 553, just with the 7 shares left. But we have incurred a loss of 385 already in selling the other 7 shares by way of stop loss. Net effect is that we have a 553-385 = 168 profit at hand. Not bad. But you might ask, if Wipro is capable of coming back then why sell the 7 shares at 316, why not wait. That is where the danger lies. You might Wait.. Wait and Wait for ever and Wipro might never come back or worse still it might continue to go down and bite the dust.
So stop loss is just that ‘Stop your loss – before it gets too bad’. The example we have taken is very trivial, but consider thousands of rupees at stake and you know its importance. To close this lesson let me tell you the funiest thing that people do when the price of their stock falls. Many people instead of stopping their loss, actually make it worse by buying more shares at the falling price. A few more think that long term investing means they can buy the shares and keep it with them without selling come what may. In the next lesson you will know why both of them are kicked out of the stock market as beggars.

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