What Is The 7% Rule In The Stock Market?

When 35-year-old Raghav purchased a promising stock, its price dropped by 7% within a few days. He thought the drop was temporary and the stock would soon recover. Unfortunately for him, the stock subsequently crashed by over 40%, and Raghav rued his losses. Had he followed the 7% rule, he could have minimised his losses.

But what is the 7% rule, and how can it be your saviour when markets go down? Let us find out.

What Is The 7% Rule?

The 7% rule is a well-known risk management rule in the stock market. As per the 7% rule, if your stock’s price drops 7% below the price you paid for it, you should sell it. Let us understand it with an example. Suppose you purchase a stock at ₹1000. The price of the stock falls to ₹930 [₹1000 - ₹70 (7% of ₹1000)]. As per the 7% rule, you should sell the stock and move on.

Doing so can help you limit your losses and avoid bigger ones. This rule was popularised by American businessman and stockbroker William O’Neil.

Why The 7% Rule?

Now, the question is why the 7% rule and not 5%, 6% or any other per cent. According to research, quality stocks rarely decline by more than 7% or 8%. However, if there is any fundamental problem with the company, it can fall even further. The 7% rule acts as a red flag or signal to exit. Doing so can help you avoid substantial losses in the long run.

What Are The Benefits Of Implementing The 7% Rule?

Following the 7% rule in the stock market and trading can spell several benefits. Some of them are:

Avoid Bigger Losses

Nobody likes to lose money. However, stock markets are volatile. Also, a stock’s performance depends on various factors. As an investor and trader, you need to adopt strategies to avoid losses in the event of extreme market volatility. In other words, the 7% rule helps avoid bigger capital erosion.

Takes out Emotions

Emotional decision-making is quite common in stock markets. Not only in a bull market, but investors also tend to give in to their emotions in a bear market as well. When a stock price falls below 7%, many remain invested, believing it will eventually recover. It is difficult for them to accept the fall. However, the 7% rule helps you invest sans emotions.

Helps You Stay Disciplined

Stock markets require discipline. Following the 7% rule helps you stay disciplined with your investments. You stick to a system regardless of the mood or market noise. This discipline can help you navigate the market ups and downs with ease.

How to Implement the 7% Rule?

There is an easy way to implement the 7% rule. It is by executing a stop-loss order. A stop-loss order is a trading instruction you give to your broker to automatically buy or sell a stock when it reaches a predetermined price. Doing so ensures you do not have to monitor prices regularly. Let us understand it with an example.

Suppose you have bought a stock priced at ₹2000 and have placed a stop-loss order at ₹1860. It means as soon as the stock price reaches ₹1860, it gets sold. Most brokers provide the facility to implement a stop-loss order through their platforms.

Things You Need To Be Mindful Of

While the 7% rule can be a powerful tool to avoid bigger losses in markets, you need to watch out for these things to maximise its benefits:

• Stock’s Volatility

The 7% rule can trigger premature exits for extremely volatile stocks. This is because high-volatility stocks can experience wild price swings. Therefore, factor in the stock’s volatility before applying this rule with a stop-loss. You can find out a stock’s volatility through its beta. If beta is more than 1, the stock is usually considered volatile. On the other hand, if beta is less than 1, it reflects stability.

• Your Investment Style

Your investment style matters while following the 7% rule. For example, if you are an intraday trader, you may not follow the 7% rule to the core. In other words, you may set up a tighter stop-loss order at less than 7%. On the other hand, if you are a long-term investor, you can set a wider stop-loss order.

• Extreme News Events

Stock prices can swing wildly during extreme news events. Major policy changes, global events, or any significant corporate update affect prices. Hence, you need to be calm and analyse the fall before following the 7% rule.

Conclusion

The 7% rule, if used well, can not only help you avoid big losses but also bring discipline into your investments. You can make the necessary adjustments based on prevailing circumstances and use them to your advantage.

Sources:

Economic Times
IFMC Institute
Investopedia