How to Calculate Stop Loss

When we talk of intraday trading, we think of stopping losses. But that raises several questions. How to calculate stop loss and how to determine to stop loss levels? If you are wondering how to calculate stop loss for intraday trading, you must surely read on. For the sake of simplicity, we will focus only on how to calculate stop loss for intraday trading and not discuss other asset classes. For example, we will not be dealing with how to calculate stop loss for options or futures or even for currencies and commodities.

How is stop loss determined?

To understand how to calculate stop loss, you must be clear about two aspects. Firstly, what is the loss that you willing and able to take? Secondly, what are the best technical levels to set the stop-loss? It is only when you answer these two questions that you can answer how to calculate the stop loss. Let us look at 3 important approaches to calculate the stop losses.

• The first approach to calculate the stop loss is called the Percentage Method. This is popular among intraday traders to set stop losses. Here the permissible loss is determined based on a percent. For example, if you buy RIL at Rs.2300 and set a stop loss at 0.8%, then your stop loss for buy position will be set Rs.18 lower i.e., at Rs.2282. That is the maximum you lose if a trade goes wrong. However, factor in brokerage and statutory costs also when setting stop losses.

• The second approach to calculating the stop loss is called the Technical Support / Technical Resistance approach. This is a tad more complex but also more scientific. Most of the seasoned intraday traders are known to use this approach but it needs an ability to read charts with finesse. In the case of buy positions, the stop loss is set below the support and for sell positions, the stop loss is set above the resistance.

• Perhaps, the best method is the Moving Averages Method to set the stop loss. How does this method work? You can first identify a long-term moving average which will be your guiding point. You can take a call on whether you want to use simple moving averages (SMA) or exponential moving averages (EMA). Once the moving average has been identified and frozen, set your stop-loss slightly below the moving average level for buy positions and slightly above the moving average line for sell positions.

The moral of the story is that irrespective of the method you use, the idea of keeping stop loss is mandatory. You must never try to trade intraday without proper stop losses in place. That is like insurance and protects your capital and also ensures longevity as an intraday trader for a longer period.

How to set stop loss?

This is one of the most important decisions for an intraday trader. Stop-loss serves as a kind of insurance for the trader and also tells how much the trader stands to lose on a particular trade if the stock moves against them. Even the best of traders in the world don’t get all their trades right and that is where stop losses fit in. The stop-loss order helps minimize loss.

The first question is whether stop loss should be a forethought or an afterthought? It must be aforethought. An intraday trader must assign the stop loss level beforehand itself. When the stock price reaches the stop loss level, the transaction is automatically terminated. The trader may lose a small sum of money but in the process can protect the capital from eroding too much. Just a word of caution, don’t keep moving your stop loss unless justified.

As we have discussed, the stop loss can be set based on a percentage basis, support/resistance basis, and moving average basis. The trick to use stop losses to protect risk. Stop-loss indicates the level of risk or loss you are ok with and that does not substantially damage your capital.

Risk reward is very important for trading intraday. No point in setting a 1% stop loss and 1% price target. The golden rule is to have a ratio of 2.5: 1 or 3:1 for effective intraday trading. Stop loss is normally a trade-off. If you set the stop loss level too far, you run the risk of losing a lot of money if the stock price goes against you. On the other hand, if you set stop loss level too close to buying price or selling price, these stop losses can trigger with the slightest spike in volatility and that is not good news.

What is margin trading?

Have you come across a situation where you were sure of stock, but did not have the funds to buy it. Worse still, if the stock soared, you must be cursing your bad fate. Margin trading is a facility under which you buy stocks that you can’t afford, so it addresses that problem for you. You are allowed by the broker, through the financing NBFC, to buy stocks by just paying a marginal amount of 15-20% of the actual value.

The advantage in margin trading is that this margin is paid either in cash or in shares as security, but such stock as security will be subject to a haircut. Margin trading is like leveraging positions in the market either with cash or security by investors. The margin can be settled later when you square off your position. Ensure that you make a net profit after interest cost, as otherwise, the exercise is not worth the trouble.