Many traders are happy to take relatively small to medium-size profits on a regular basis to keep their investment pool growing. As a consequence the idea of a stop loss limits is very appealing because it allows you to increase your stop loss limits as a share price rises and then bank a profit when it falls towards your stop loss limit. The idea is then gradually as the share price rises you’re able to limit your downside and maximise your profit.
Allowing for natural volatility
While there are no hard and fast rules regarding stop loss limits many people like to give themselves 10% leeway on the share price. For example if the shares rise to £2.00 then they will set a stop loss limit at £1.80. The idea is that this will allow for natural volatility with a 10% reduction in the share price seen as a change in the share price trend. This may be too tight for some shares therefore you will need to adapt to the specific stock in question and general market conditions.
The more you use stop loss limits the more of an understanding you will get for general market volatility and a change in trends. These are very different situations because ultimately you want to sell and take a profit when the trend changes, ignoring relatively small share price volatility.
Sticking to your stop loss limits
Stop loss limits are basically there to stop you from thinking and encourage you to act when the share price hits your stop loss limit. If you begin to pick and choose which stop loss limits you follow then this allows emotion to get into your decision-making process which for many people can be a disaster. As we have mentioned on numerous occasions, if you find it easier to take the emotion out of buying and selling shares by thinking of them as “boxes” then do so. This will stop you from thinking what the company does, what the prospects may be in the longer term and whether indeed you should ignore your stop loss limit and continue to hold.
Unfortunately, the investment arena is full of investors who decided to ignore their stop loss limits and are left holding shares which are but a fraction of their previous value. Remember, a stop loss limit also works when taking a loss because while it is the hardest thing to do it is important to protect your long-term investment pool.
Limit your downside and maximise your upside
In an ideal world you would move your stop loss limit higher and higher as the share price moves up. This allows you to take full advantage of the upside and also protect yourself on the downside as and when the trend does change. It goes without saying but no stock will continue moving higher forever and a day, so, if you are trading in the short to medium term you need to protect your profits.
There may well be occasions where you think a share price has pushed too far ahead, and is nowhere near your stop loss limit, but at the end of the day there is nothing wrong in taking a profit.