We all understand the concept of stop loss while trading. When you trade in the markets, you invariably trade with limited capital. That means; your primary aim must be to protect your capital from depleting beyond a point. That is what a stop loss is all about. It is the level at which you terminate a trade and book the loss to protect further depletion of your capital. Remember, stop losses are applicable irrespective of whether you are in a long trade or in a short trade. If you are long on a stock then your stop loss will be below your initiation price and if you are short on a stock then your stop loss will be above your initiation price. But, first let us understand how you set a stop loss for a trade?
How to go about setting a stop loss?
This is a very fundamental question that any trader needs to ask before initiating the trade. There is a primary question as to whether a stop loss should be set at the time of initiating the trade or one can observe the markets and then put the stop loss. It is always better to fix the stop loss at the time of the trade as you are then saved from any sudden spike in volatility. You can actually measure the impact on your capital in a worst case scenario. There are broadly 3 rules that you can follow while setting your stop loss.
Firstly, the stop loss has to consider your ability to absorb capital loss. If you have a smaller capital base, your stop losses need to be closer even if it entails higher risk. Remember, protecting your capital is the primary goal of stop losses and that has to be respected. Secondly, technical charts are important portents of a trend change. You normally set a stop loss slightly beyond a major support or resistance level. The logic is that these technical charts are based on past experience and therefore capture collective wisdom. Lastly, there is the condition of proportionality that you have to maintain between stop loss and your profit target. A 2% stop loss and a 2% profit target is a bad risk-return trade-off. A minimum ratio of 1:3 should be maintained when setting stop losses!
Coming down to trailing stop losses..
To understand the concept of a trailing stop loss, let us assume that you bought HUDCO at a price of Rs.77 in the cash market since it is not currently available in the futures. You intend to hold this stock for delivery with a target of 85 in one quarter. However, the target of Rs.85 is achieved in the next 7 days itself. In fact, the stock opens on the eighth day gap-up at a price of Rs.90. What should you do? Should you take your profits off the table or should you hold on to the stock. Basic trading online and investment prudence tells you that when the profit target is achieved then you must exit your position. But you also have just received a research report from your broker on HUDCO with a price target of Rs.125 as a very strong play on the affordable housing story. If you are convinced by the argument and have the capacity to wait, what exactly should you do? The answer to your dilemma could like in a Trailing Stop Loss.
Solving the problem with a trailing stop loss..
In the above case of HUDCO, if the stock has touched Rs.90 you can check the technical levels of the stock. If the support works out to be Rs.86, then you can instruct your broker to book profits if the stock falls to the Rs.86 levels. Alternatively, if you are trading online then you can set a price alert for HUDCO at Rs.87 so that you get an alert as soon as that price is breached giving you enough time to trigger your trailing stop loss at a price of Rs.86. This trailing stop loss ensures that your profit up to a point is protected and you do not end up losing all the appreciation. In case of intraday traders, your broker will typically permit you to define a trailing stop loss in such a way that the stop loss gets automatically revised upwards as the stock price goes up.
The trailing stop loss serves two purposes. Firstly, it acts as a protection against loss of capital. Secondly, it also acts as a cushion to protect your profits so that at some point your notional profits are translated into real profits.
Using futures and options as a trailing stop loss..
One of the alternatives is to use futures as a proxy for a trailing stop loss. So if you have bought the stock at Rs.100 and the stock has gone up to Rs.140, but your target is 160 then you can sell futures at Rs.140. But that will put a cap on your profits at that price. You can also mirror a trailing stop loss by purchasing put options of higher strikes but that again entails a cost in the form of an option premium as well as transaction costs. That has to be factored in!
The moral of the story is that trailing stop losses provide you a useful tool to protect your profits as well as continue to protect your trade at a more meaningful level. It is the perfect compromise between the discipline of a stop loss and the discipline of profit booking for a trader!