Hope you managed to live through our previous article on stop losses and liked the experience. If you haven't, we seriously recommend you follow this link and do so. That way you will be in context and we will be on the same wavelength. Hopefully.J
Okay, we doubt if we have said anything so far, that most traders don't already know. Everyone knows about the unpredictability of the markets. Everyone knows that using stop losses is an effective method of dealing with the uncertainty.
But despite this, we also seriously doubt if most traders use stop losses. Why? Its not because they don't realise the perils of trading without one. It is not because they find the arithmetic of setting a stop loss so difficult that they can't figure it out. It is just that they can't get themselves to do it.
'Stop loss' is not a four letter word
We remember this time when we advocated the use of stop losses to a stock market veteran. He was quite upset that we were talking about losses even before putting the trade on. "Shubh shubh bolo", he admonished us.
Most traders relate to stop losses as being something negative and pessimistic. Frankly, we don't see why. We don't know of anyone who burnt his or her tongue screaming "Fire". But we do know plenty who are thankful for their foresight in buying a fire extinguisher. Like we said earlier, using a stop loss is not a sign of your lack of conviction in the trade. It is a sign of lack of conviction in the mood of the market.
A 'mental' stop loss is no stop loss
The one thing you must know for certain before you put out a trade is what your cut loss level is going to be. And you must put this figure in at the time of entering the trade. You must actually key in the trigger and stop loss levels. A "mental stop loss" rarely works.
The value of this method is easy to see. First, you clearly define at the outset the loss you are willing to take on that trade. Second, you set the process of defining risk in motion while you are feeling calm and unthreatened by the market. This way, you have the advantage of a logical and rational mind-set when you define your stop loss beforehand.
But once the trade has been initiated, this mind-set is very very difficult to achieve. Once you have a position in the market, you no longer control the fate of your trade. The market does. And when you are sitting in front of the trading terminal, you are reacting (and not acting) on the spur of the moment to the market's every move. That is no frame of mind to take rational decisions from. Hope, fear, anger, joy, disappointment, greed - a variety of such emotions - stand in the way of your efficiently executing a stop loss and getting out of the trade before getting burnt.
So how is a stop loss set?
The simplest way of setting a stop loss is by deciding how much, in absolute terms, you are willing to lose before the trade is put on. And squaring off the trade when you have lost that amount. Though it may sound simple, traders find it the most difficult to implement. How does one decide how much one is willing to lose?
The risk-reward ratio
The most efficient way of setting your stop loss is by setting it in relation to how much is sought to be made on the trade. You will agree that a trade that offers a gain of 10% with a risk of losing 10% is not worth looking at. Why? Because, to start with, every trade already has a 50:50 chance of going right or wrong. The risk-reward equation of 10% either way does not improve these odds substantially. But if the same trade offered a gain of 10% with the risk of losing 2.5%, then the trade would make sense to you. Because this way the odds are stacked in your favour. The probability of making 4 times the amount lost is built into this equation.
So then, the most efficient way of setting the stop loss level is to estimate the amount of profit potential in the trade and then divide the figure by four. This, when subtracted from the initiation price in the case of a long trade, will give you the level below which the trade must be exited.
Illustrating the risk-reward ratio
Assume that stock X is trading at Rs200 and you have reason to believe it will move up to Rs300. The way to trade this call would be to put a stop loss at Rs160. How? The minimum profit expected equals Rs100 (Rs300 less Rs200 equals Rs100). This divided by 2.5 gives Rs40. This when subtracted from the current market price of Rs200 will give the stop loss level of Rs160. That is, 200-[(300-200)/2.5].
If, on the other hand, you expected the price of stock X to halve, then you would go about shorting it with a stop loss at 240. Again 200+[(200-100)/2.5].
Remember that what is important is only the relationship between the risk and reward. The absolute numbers do not matter. So if there is a trade that you think can earn you 40%, by all means work with a stop loss level of 8-10% below the current price.
Three weeks in a trader's life
Let's take some examples. Suppose you make 10 calls a week. How much money do you lose if you used the 1:2.5 risk-reward ratio?
| . | AverageWeek | Bad Week | Horrible Week | |||
| No of trades that made money | 6 out of 10 | 4 out of 10 | Only 3 out of 10 | |||
| % gain on winning trades | 6 * 2.5% | 15% | 4 * 2.5% | 10% | 3 * 2.5% | 7.5% |
| % loss on bad trades | 4 * 1.0% | 4% | 6 * 1.0 % | 6% | 7 * 1.0% | 7.0% |
| Net gain/loss | - | +11% | - | 4% | - | 0.5% J |
Look at the performance in the horrible week. A net gain of 0.50%. Certainly nothing to write home about. But the point to be noted here is that by using a stop loss you have managed to protect your capital and keep it intact!
The brilliance of this strategy is not only the risk-reward ratio, but also the leeway it provides you to control losses. You are guaranteed to make losses on some of your trades. And you don't need a second opinion on that. The objective in stock trading is not to make money on every trade (again one has to look to the skies for a method of doing that), but to make money consistently.
I've lost more times than I've won. I am good!
There have been many successful traders who claimed that the number of bad trades actually outnumbered the ones that made money for them. But, net-net, they still made money because they had no large losses and a few big profit trades.
We always thought these claims were a bit exaggerated. Till we worked out the arithmetic ourselves and realised that it need not be so. If a successful trader claims his losses actually outnumber his gains, but that he makes money overall, we have no good reason of accusing him of exaggeration. But we still believe a good trader should make at least as many gaining calls as losing calls.
Let's recap
- You need to always work with a stop loss, no matter what your trading timeframe is.
- Traders always need to put in their stop losses at the time of initiating the trade. A mental stop loss is no stop loss.
- The best way to put your stop loss is to give yourself the advantage of a 1:2.5 risk-reward ratio at the very least.
- Your objective should be to make money consistently and not necessarily on every trade.
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