when dabbling in stocks, stop losses first

the number of retail investors and traders in the Indian stock market has shot up dramatically in the last year. in August 2019, 2.5 lakh new investors entered the stock market. this number rose to 8.24 lakh in August 2020 and a year later, it nearly doubled to 14.9 lakh in August.

the new entrants — many of whom are millennials — are dabbling in the stock market at a time when ‘stonks only go up’ has become a battle cry of sorts. they are yet to realize the consequences of what happens when ‘stonks’ don’t go up but fall.

understanding stop-loss

no one rings the bell when the market bottoms, but it is bound to correct at some point. so, how does one prepare for the inevitable? it depends on your approach to the market. 

if you are in it for the long run, then you can risk being patient and waiting for prices to bounce back. but if you’re a trader, like most of the new entrants in the market, then it is necessary to understand the importance of a ‘stop-loss’ order.

a stop-loss order is an order which gets executed automatically at a price level of a falling stock.

let’s say you want to trade a stock that you bought at Rs 100 hoping it rises intraday or in the next few trading sessions. but what if the stock suddenly falls by 30%? you’ll lose Rs 30 per share and you can still be at risk of losing your entire principal amount if you don’t sell.

a stop-loss order is helpful in such a situation. if in the above scenario had you place a future order which is to be executed when the stock price falls to a certain level, let’s say Rs 95 per share, then you risk losing only Rs 5 per share in case the stock falls beyond that level.

why it is important

this helps in cutting losses, saving the principal, and also brings about a certain discipline which is important if you are actively trading.

for an active trader, it’s more important to have cash on hand than to wait and hope for bad bets to recover. closing such positions on time and moving to another trade can even help to compensate for the loss incurred in the previous one.

booking losses can help with tax harvesting as well, where the loss on the sale of shares is offset against the capital gains tax liability. traders, who will mostly be taxed as per short-term capital gains, can use this to limit the amount of tax they would have to pay on their gains.