A practical example:
A reader Sbalu wanted to know how to set his stop-loss.
Sbalu asked:
''I am planning to invest Rs.700000 in one lot of Jindal Steel & Power futures and I expect this to go up substantially (CMP 15460 & target Rs.17000 in less than 10 days). One lot is 125 shares.
What should be my Stop loss in terms of rupee value and in percentage? I NEED your input at the earliest as I am planning to buy it tomorrow.''
Answer:
In this calculation, I have followed a 2-Step approach:
Step 1. First I will calculate the stop-loss based on the volatility of the stock. (Volatility Stop)
Why? A Volatility Stop ensures that the stop-loss is not triggered by normal volatility of the stock.
This step disregards his personal risk tolerance.
Step 2. Next, I apply position-sizing to make sure that he can comfortably observe the stop-loss without losing more than 10% of his capital.(Please note, that the actual Volatility-based Stop loss can be well over 10% of his entry price. But with position sizing, we can ensure that Sbalu 's losses are capped at 10%)
So here goes:
Your Volatility Stop
Most traders follow a simple method for calculating their Volatility Stop.
They subtract a multiple of ATR from the entry price.
For short-term positions, it is 2xATR = ( 2 times Average True Range)
For medium-term positions, it is 3xATR = ( 3 times Average True Range)
For long-term positions, it is 4xATR = ( 4 times Average True Range)
Let us assume that Sbalu 's position is for the medium term, therefore, we will set our stop at:
3xATR = ( 3 times Average True Range)
Here ATR is the Average True Range of the stock.
For the purpose of calculating stop-loss, most traders use 15-day ATR (Average of True Range* Calculated over last 15 days)
I got the 15-day ATR by going to iCharts.in and generating the chart for JINDALSTEL with
As you can see in the chart above, 15-day ATR for JINDALSTEL is 12723x1272 = Rs. 3816
Now we need to subtract the result from his entry price.
Let us assume that he entered the position at today's opening price, which is Rs. 14200.00
Therefore, our stop-loss price is at:
14200 - 3816 = 10,384
Thus, if he bought JINDALSTEL at 14200, then his stop-loss would be triggered at 10,384 (stop loss price)
With a lot size of 125 shares, this trader stands to losers. 4,77,000 if his stop-loss is triggered
(whoa! The gravity of the calculation I'm doing has just started to dawn on me.)
This is where Position Sizing comes in.
Now let’s assume that the trader wants to lose no more than 10% of his capital.
In this case, the capital is
12400 (entry price) x 125 (lot size)
= 1775000
For now, we assume that this trader does not want to lose more than 10% of his capital, which caps his losses to10/100 x 1775000 =177500 (loss amount)
What should his position-size be? Given that our loss per share is capped at Rs.3816 (3 x ATR)
Then, the maximum number of shares he can buy is:
177500/3816 = 46.5 shares
Position Size that caps your loss at 10% of your capital: Approx 47 shares
Sbalu , if you want to enter this stock (1 lot) for the medium term, then you must be prepared to lose about Rs 4 lac 77 thousand.
Are you comfortable with that? If so, go ahead.
If you are not comfortable with losing this much, you can reduce your position size and buy 47 shares to cap your losses at approx Rs. 1 lac 77 thousand (= 10% loss of capital)
What about a tighter Stop Loss?
You also have the option of observing a tighter stop at 2x ATR.
(In the previous calculation we observed 3xATR stop-loss)
This works out to Rs. 2544 loss per share.
(So your stop-loss price would be
Rs.12400-2544 =
Rs. 11656)
Considering the lot size of 125 shares, your losses would be capped at:
Rs. 2544 (2xATR) x 125 (Position size)
= 3, 18, 000
Are you comfortable with that?
Please note that with a tighter stop-loss, you have a higher chance of getting whip-sawed out of a potentially profitable position.
Should you get into this position?
Look at the potential gain vs. potential loss.
You said your TARGET Price for this share is
Rs. 17,000
So your potential gain is:
(Target - Entry x Position Size)
17000-12400 x 125
= Rs. 5, 75, 000
Risk Vs. Reward of this position:
Are you willing to lose Rs. 3, 18, 000
to potentially make Rs. 5, 75,000?
Is it a GO?
Make a calculated decision!
Each time we buy or sell in the stock markets, we face a risk of loss. If we're able to quantify the loss in numbers, before we get into the position, we can then manage the trade with peace of mind.
That's effective risk-management!
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