Stop Loss Strategey

STOP LOSS STRATEGEY

Question and Introduction:

Discuss the Stop Loss Strategy case study based on knowledge learned from Unit 1. Support your responses/thoughts with evidence based in readings, peer-reviewed articles, and other verified sources.

Stop loss strategy is a trading tool that is put in place to prevent investors from holding their losing investments too long by automatically prompting the sales of losing investments what a particular price is reached. This strategy is mainly design or used by investors and brokers to minimize their losses.

Most investors has disposition effect. This is when investors general tend to hold their losing investments too long and sell their winning investments too soon [1][2]. Only a handful or few investors comprehends the saying “cut your losses and run your profits” [1]. This suggests that this tendency arises from behavioral biases such as mental accounting, pride seeking, regret avoidance, and the lack of self-control. For this reason stop loss strategies was designed as one possible remedy for this behavioral tendency and to help prompt the sales of losing investments. A stop loss strategy allows an investor to specify a condition under which a losing investment is automatically sold. Because investors do not have to make contemporaneous selling decisions, stop loss strategies can possibly prevent.

Advantages and disadvantages of Stop loss strategy

This strategy has number of both advantages and disadvantages.

Advantages

- Reduces the investor’s financial loss.

- Allows you to know exactly how much money/investment you are risking or losing beforehand. Because you set up the amount or price at which the stop loss order should be executed, therefore any loss that comes is never a surprise.

- It also allows you to plan your risk : reward ratio very easily. The risk : reward ratio is the ratio between how much you are willing to lose to the potential profit. For example if you are risking $1 for a given trade with the potential to win $5 you will have a risk : reward ratio of 1 : 5 [3].

- It help reduce and eliminate continues monitoring

Disadvantages

- One of the disadvantages is notice is that, in case of short term fluctuation of the market you will loss and not gain.

Example: if I buy a $1,000 IBM stock and set my stop loss price at $980. Whenever there is a little fluctuation (depreciates) on this stock which equal to $980 or less the stock will automatically be sold. Although risk has been minimized but if there is rise in prices after of the stop loss order has been executed I can gain because it has already been