Why StopLoss is your best friend?

Why StopLoss is your best friend?

Many of us including me hates when we get out of a trade due to stop loss hit!

Let’s consider a scenario where you want to start a traditional business, what will you do, you will make some investment, buy some material and sell it with some profits, equation is simple.

Say, you buy something for 40 Rupees and spend 20 rupees on top of it to transport or add value and sell it for 100 rupees, your total investment will be 60 rupees and your profits will be 40 rupees.

Selling Price (100rs) – Cost Price including expenses (40rs+20rs) = Net profit (40rs)

This is how we do business for centuries and the calculation is recorded in our minds in such a way that we never question it.

Now let’s take another scenario of your trading business, here you don’t buy raw material, rather you buy equities, but if you pay 100rs you will get equities worth 100rs and there are expenses like brokerage and taxes. Now if you sell the holding for 200rs, here the equation is –

Selling price of stock is 200rs and cost price is 100rs investment + 5rs brokerage and taxes, so the total profit is 95 rupees.

Selling Price of stock (200rs) – Buying price including expenses (100rs + 5rs brokerage) = Total profits (95rs)

Which business gives you 95%+ returns in the world on your investment? Probably none other trading can!

Everything looks perfect till this time, but what if you make hundreds of trades, it’s impossible to win every time, you will have some losing trades and the loss which you make IS THE COST of your business. So assuming the win rate as 70% and Risk reward ratio as 2:1, let’s update our equation for 100 trades now.

Total Profits made (95*70=6650) – Total loss made (55*30=1650rs) = Net Profits (5000rs)

Perfect! it matches with the traditional business model now. Some profit – some cost = net profit.

Now, what a trader need to ensure is not to skew this equation like this.

Total Profits made (95*70=6650) – Total loss made (105*20 + 505*10 = 7150) = Net Profits (-500rs)

Or even worse and most common figures of:

Total Profits made (95*70=6650) – Total loss made (105*20 + 1005*10 = 7150) = Net Profits (-5500rs)

This is where your money management and risk/reward ratio comes into the picture. Keep your stop losses equal or smaller than profit targets, trade at least with 1:1 RRR. Exit when your SL hits and keep riding your winners as long as you can. This will ensure you will have net profit at the end of the week/month/year.

StopLoss is there to stop your loss at some point, it is a saviour, a friend who limits your damages and saves you from the worst. Stop treating it like an enemy and embrace it like a friend, that’s the most important ingredient for successful trading.

For more details and explanations, watch the video: