Using Stop Losses

Using Stop Loss

Ashwani Gujral | Excerpt from How to Make Money Trading Derivatives by Ashwani Gujral.


A stop is that predecided point on a chart which defines the amount of risk a trader is going to take.

There are various methods of placing stops and then trading them. Stops are as much about initiating trades as they are about trade management once the position is in the money. It is very critical for a person to be clear about the methodology of placing stops, and adhering to it once the trade is initiated.

To my mind, keeping mental stops, or having very close stops , or changing stops mid-trade are all counter productive. Stops placed too close often get hit because of noise or random movements in the prices of stocks/futures, while stops placed too far may actually skew risk and return. However, a trader has to assume that no trade will be his last; all traders realise that sustainability in the business is key to making profits.

The reason for putting stops is to pre-define your risk and also to avoid getting frozen into inaction when a position starts going against you.

The Functions of a Stop


A stop has two useful functions.

1. First, it preserves capital when a trader is wrong. As sustainability in the business is the key to profits, its important that the trader does not lose more than a predefined amount when he is proved wrong.
2. The second function of a stop loss is that it help measure profit in terms of the risk taken. If a trader risks an X amount in every trade, he can thus measure his profit in terms of 2X, 3X,....10X etc.


Tackling Market Noise


Intra-day market movements usually have no material impact on the overall trend. In fact, most of these gyrations are caused by very temporary demand supply mismatches. Thus a trader has to keep his stop losses far enough so that the noise does not throw him off the trade. This judgement is usually developed with years of practice. Although theoretically it appears a fine idea to buy breakouts out of ranges and patterns , or trade overbought and oversold levels, in reality a market often does nothing after these breakouts - and sometimes even reverses for a while before proceeding with the original trend. The key here is to keep a wider stop and size your positions according to the money management rules.

The key is to have a strong body of evidence before you enter a trade. Buy or sell signals should be matched across time frame, the breadth of the market has to be considered, and then the stops need to be placed in an area where the stop may not apparently logical. I say this because "logical" stops will usually be taken out by the market in case it reverses temporarily. Even after all care is taken, the stops may still be hit by strong counter moves called whipsaws but the number of such instances can be reduced. The Average True Range (ATR) can be considered to be the measure of market noise.

Methods of Placing Stops


Tight Stops
Being a swing trader, I generally hold my positions for 4-5 days. I use tight stops as trailing stops only once I am deep in the money in terms of profit. I do so as a method for protecting my profits rather than when entering a position. This is my opinion as a swing trader.

There are certain other advantages of tight stops. First , you lose much less money when a trade is aborted. Second, because of your small loss, you can make multiple attempts at re-entry. And, third, if you get such a move , your profit will be many times the amount of your initial risk.

Equally , tight stops have some serious shortcomings.

Tight Stops result in many more trades in order to generate the same profits. In markets which are not trending very strongly, sometimes your stop can keep getting hit before the market moves in the desired direction.

The other downside is that transactions costs add up since tight stops lead to over trading.

My Personal view on tight stops continues to be that they should be used when a trade is substantially in the money and the market is showing signs of reversing. You can then protect a large part of your profit by putting a tight stop.

Choosing a Stop
The factors which determine the nature of the stop are:

* A trader's objectives and the nature of his trading - IE day trading, position trading, or swing trading,
* The concept that is being traded, and
* The trader's temperament.


Lets look at some of the stop strategies

Rupee Stop
Rupee Stops have certain benefits; for one, they define beforehand how much you can lose on a trade. These stops are also not predictable because they are not placed on the obvious supports and resistances on the charts. IF these stops are placed some distance away from a support, they can be very effective.

But traders need to keep in mind the rules of money management and position sizing while using rupee stops. Personally, I believe in an upper limit on the amount being risked on every trade, but on the lower side each trade is different, each situation is different, and it would be a mistake to have a standard rupee stop loss for all situations.

Percentage Stops
Some people set stops by allowing the price to retrace a certain percentage of the price. This practice is fine so long as the percentage is based on an objective criteria like a pivot. Arbitrary percentages on the other hand; will often lead to inefficient trade management, which usually means not achieving the entire profits possible.

Volatility Stops
Volatility stops are based on the assumptions that, to at least some extent, the volatility represents noise. So if a volatility stop is placed at some multiple of the ATR, then the probability is that the stop is beyond the immediate noise of the market.

Time Stops
A good trade works immediately. A trade which meanders around the break even level, or goes sideways; more often than not does not work out. Technical Analysis is not an exact science, and patterns and breakouts can and do fail, particularly in non-trending markets. So its important for the trader to keep an open mind and if a trade is not working within the time that he is comfortable with, he should reevaluate he evidence and re-consider whether to continue in it. Getting out of a potentially unprofitable trade is also a strategy; the trader is not a lose r if he gets out of a trade that is not working. You can always get back into the position if the stock or the index starts a move. Always remember, you cannot arm-twist the market to give you profits, so learn to observe its steps and dance with its rhythm.

Pivot Stops
These are the stops that I use most extensively and have been very useful in my trading so far. I like to place these stops a couple of points above and below the previous pivots, since placing pivot stocks is a well known methodology. The larger the time frame on which the pivot is broken, the more is its relevance. Breaking of pivots often show breach of support or resistance; also it shows strength and weakness.

There are certain rules to follow while using stops.
First I never change my stop; unless its a trailing stop, my risk is the same on every trade since I do not differentiate trades on the basis of expectation.

Second, if my stops are hit and I take a loss, I stand back and review the market action for two possibilities:

1. My analysis was wrong. In that case, I try to see if I can reverse my position in the same trade because a failed breakout in one direction leads to a strong move in the other.
2. I try to see if we are in a choppy phase of the market. If that is the case, I just fold my hands and sit back because my experience suggests that only market trends give traders money; and choppy markets take all of it, and more back.


I use pivots both to enter and exit trades. Breaking of an up pivot show strength, breaking of a down pivot show weakness.

* I always buy a market which, along with other evidence of a market moving up, breaks the nearest upward pivot.
* I sell a market which, along with other evidence of market going down, breaks the nearest downward pivot.


So the pivot is the trigger for all my actions. If a pivot is broken in either direction and the market whipsaws back in the opposite direction, it is prudent to wait till the market makes the next move and reduce volumes drastically on further trades.

Shakti