If stop loss is very close to buy/sel price , it will get triggered very fast and will make me exit from the market. If its too much away from from Buy/Sell price I will suffer more loss. How should I optimize the stop loss value to keep me in the market and minimize my loss also.
Many investors struggle with the task of determining where to set their stop loss levels. Investors don’t want to set their stop loss levels too far away and lose too much money if the stock moves in the wrong direction. On the other hand, investors don’t want to set their stop loss levels too close and lose money by being taken out of their trades too early.
following three methods you can use to determine where to set your stop losses:
- The percentage method
- The support method
- The moving average method
One reason for this method’s popularity is its simplicity. All you have to do when using this method is determine the percentage of the stock price you are willing to give up before you exit your trade.
For instance, if you decide you are comfortable with a stock losing 10 percent of its value before you get out, and you own a stock that is trading at Rs.50 per share, you would set your stop loss at RS 45—RS 5 below the current market price of the stock (50 x 10% = 5).
The Support Method for Setting Stop Losses
The support method for setting stop losses is slightly more difficult to implement than the percentage method, but it also allows you to tailor your stop loss level to the stock you are trading.
To use this method, you need to be able to identify the stock’s most recent level of support.Once you have done that, all you have to do is place your stop loss just below that level.
For instance, if you own a stock that is currently trading at RS 50 per share and you identify RS 44 as the most recent support level, you should set your stop loss just below RS 44.
The Moving Average Method for Setting Stop Losses
The moving average method for setting stop losses is more simple than the support method, but it also allows you to tailor your stop loss to each stock.
To use this method, you need to apply a moving average to your stock chart. Typically, you will want to use a longer-term moving average as opposed to a shorter-term moving average to avoid setting your stop loss too close to the price of the stock and getting whipped out of your trade too early.
Once you have inserted the moving average, all you have to do is set your stop loss just below the level of the moving average.
For instance, if you own a stock that is currently trading at RS 50 and the moving average is at RS 46, you should set your stop loss just below RS 46.
Stop loss value depends on the kind of system you are trading(trend following,mean reversion). These can be of different types,most popular ones are the ATR based and percentage based stops.
Setting Stops For Long Positions
1. Set the stop just under yesterday's low unless yesterday was a big up day. Then move the stop closer to today's open. Set the stop just under a recent minor support level.
2. As the stock moves up and tends to "top out" or market conditions become unfavorable, "tighten the stop." In other words, move your stop closer to the current market price. Doing this will effectively employ an "up or out" strategy" - either the price goes up, or you are out of the trade. this is basically trailing you stop.
Setting Stops For Short Positions
1. On daily charts, set the stop just above yesterday's high unless it was a big down day. Then move the stop closer to today's open. Set the stop just above a recent minor resistance level
2. You can apply trailing startegy here as well.
Discipline trading is trading with proper stop loss.
This is an old question, saw it today..though I could share my 2 cents..
The problem with pre-fixed percentage stop-loss is in its rigidity. For example one could have a 2% stop-loss on every trade. So if you are to buy a stock at Rs.500, then your stop-loss price is Rs.490 and you risk Rs.10 on this trade.
Notice the SL does not account for the daily noise / volatility of the stock. As a result you could be right on the direction of the trade but could still hit a ‘stop-loss’. More often than not, you would regret keeping such tight stops.
An alternate and effective method to identify a stop-loss price is by estimating the stock’s volatility. Volatility accounts for the daily ‘expected’ fluctuation in the stock price. The advantage with this approach is that the daily noise of the stock is factored in. This literally means that we are eliminating the chance of placing an irrelevant stop-loss.
Volatility stop is strategic as it allows us to place a stop at the price point which is outside the normal expected volatility of the stock. Therefore a volatility SL gives us the required logical exit in case the trade goes against us.
Let me give you an example.
You are bullish on stock ‘ABC’ and plan to buy it at 185 with a target of 210, expected to be achieved in the next 5 trading sessions. In order to place a volatility based SL..
Step 1: We estimate the daily historical volatility of the stock (a simple excel calculation). Recall, volatility of the stock is a nothing but the standard deviation of the stock prices. Let us assume the daily historical volatility for ABC is about 3.01%.
Step 2: Convert the daily volatility into the volatility of the time period we are interested in. To do this, we multiply the daily volatility by the square root of time. In our example, our expected holding period is 5 days, hence the 5 day volatility is equal to 3.01*Sqrt(5). This works out to be about 6.73%.
Step 3: Calculate the stop-loss price by subtracting 6.7% (5 day volatility) from the expected entry price. 185-(6.7% of 185) = 172.
Step 4 : Estimate the risk reward ratio to check if it falls within your expected guideline. In this example we are risking 13 Rupees for a gain of 25 Rupees (Risk to Reward ratio of 1:1.9) which seems like a reasonable bet.
Note : In case our expected holding period is 10 days, then the 10 day volatility would be 3.01*sqrt(10) so on and so forth.
Hope this makes sense! Happy Trading.
Note : For the above answer, I've taken extracts from an online article that I wrote few years ago.
If you are an active trader who spends all day in front of a screen, i think best not to leave stop loss orders in the system…
Or limit orders too for that matter, never give away more information than you need to…
Try ATR, place stop 2.5X of ATR value.
Good one. Cover Order helps in this regard, if one is absolutely sure of his trade. Ideally a trader would want to have minimal stop losses if he is sure of winning the trade.
Thank you, very clearly answered
Thanks. Will check this out?
Agreed Nik, especially if you are trading a super liquid counter like Nifty Futures…even if you send a big order at Market the liquidity is good enough to suck it.
Problem arises if you are dealing stock specify trades, relatively less liquid stuff. Punching market orders can be a pain.
But you know best trader boy
@ Karthik loving your comments on this site, have started following you
Nik…this is good fun…I’m having a ball :-)…and I’m gonna stalk you as well!
Akshay, Could you explain ATR based stop loss with an example?
Karthik, Very good explanation to determine stop loss.Thanks.
I wonder how Zerodha Cover/Bracket order determines stop loss - I mean is there any mechanism or calculator?
I appreciate if you have any information about that. Thus I also learn about that technique used by Zerodha or any broker to determine the stop loss.