If you have been into intraday trading, you perhaps know that losses are an inevitable part of trading. There is no holy grail in the stock market that works like a charm. Every setup has its efficacy and none of the trade setups work with 100% accuracy. So what does that leave us with? Well, the most important aspect that comes into trading successfully for the long term is managing the losses. As intraday traders, you cannot avoid the risk of loss completely. All you can do is manage it well so that it stays in your pocket size and does not draw down your capital in the long run.
So, how do you manage the risk? There are various ways that include position sizing, which means you must trade in the quantity that you can manage. Trading in large volumes can expose you to bigger losses. Another way to manage risk is to place a stop loss order. But many intraday traders fail to understand the concept of stop loss. The most confusing aspect of stop loss is not being able to calculate the right levels.
Therefore, in this article, we will guide you to calculate your effective stop loss for intraday trading. Let us discuss in a step-by-step manner beginning with the basics.
What is Stop Loss?
When it comes to day trading, there is a huge risk involved. Since the intraday trader has to square off the position on the same day, there is very little time for reversal if the trend goes in the opposite direction which can lead to huge losses. It is the stop loss that helps an intraday trader to exit from such a wrong trade with a small loss. As the name suggests, stop loss helps you to stop out from the loss-making trade as early as possible.
Stop loss is a type of order that can be used to avoid further losses. It is not a compulsion to use stop-loss orders, but it can help minimize the risk of higher losses if the trend goes in the other direction of your trade.
Understanding How it Works
Let us look at how the stop loss works with the help of an example. Suppose, you place an intraday bet to buy 50 shares of Company ABC at 10:00 AM at Rs. 120 per share. You will make a profit if the stock price picks upside momentum above Rs. 120. But if the stock price falls below Rs. 120, you will make a loss.
Your analysis suggests that the stock price might go a few points below Rs. 120 but if it goes below Rs. 112, it will pick up momentum on the downside and the price can fall further. So, to cap your loss in case of the downfall, you can place a stop loss at Rs. 112. Now you know that if the trade does not work out in your favor, your maximum loss will be Rs. 8 per share and the total loss from the trade will be Rs. 400.
So How Do I Calculate My Stop Loss?
Calculating the right stop loss level is the biggest struggle amongst novice traders. The stop loss has to be at an appropriate level that fits the pocket size of the trader. Keeping wider stop loss can result in capital drawdown whereas the regular price swings can make you exit the trade if your stop loss is narrow.
So what is the correct level to put a stop loss order? Well, you can use either of the following three effective methods that traders use –
- Percentage Method
- Moving Average Method
- Support/Resistance Method
What is the Percentage Method?
It is the most commonly used technique to calculate stop loss for intraday trading. As per this method, the stop loss is calculated based on the percentage of the stock price. For example, suppose you short a stock with the price of Rs. 500. You can set a fixed percentage, say 10%, as your stop loss. In this case, since the stock price is Rs 500, your stop loss will be Rs. 550, that is, 10% above the price at which you shorted the stock. If the trade does not go in your favor, your maximum loss will be Rs. 50 (Rs. 500 x 10%).
What is the Moving Average Method?
This is one of the easiest methods for computing stop loss for intraday trading. In this approach, an indicator called ‘moving average’ is first applied on the charts. It will display a line of average that moves along with the price. Once the moving average line is plotted on the chart, you can use it to ascertain your logical stop loss with ease.
Here’s how. If you are in a long trade, your stop loss can be below the moving average line. As in the case of a short trade, your stop loss can be below the moving average line. It is recommended to keep a little buffer in price to make room for volatility. Moving averages are available with different lengths. The longer the length of the moving average, the higher the effectiveness is.
What is the Support/Resistance Method?
To follow this method of stop loss, you need to be familiar with the support and resistance zones on the charts. Support level, in simple terms, means the level at which the falling prices take a halt. This is because buyers absorb all the selling pressure and do not let the price fall below that level. Since, at the support level, there is demand for the stock, it is also known as the demand zone. The exact opposite of that is the resistance zone. When the price goes up and falls again from the same level, it implies that the sellers are actively selling at that level and stock resists going above that price level. Since there is a supply of stocks at that level, it is also known as a supply zone.
After you ascertain the support level, you can place your stop loss for long trade below the support level. In case of a short trade, you can place your stop loss order above the resistance zone.
The Bottom Line
Most intraday traders fail due to overexposure to losses. To be consistently profitable in the stock market, you must keep a strict stop loss for every trade you enter into. This will not only help you manage loss in the wrong trades but also protect your capital in the long run.
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