Stop loss serves as a measure that tells you how much you stand to lose on a particular trade. It’s important to calculate stop loss beforehand so you can be prepared if a trade switches it’s direction. If the price of a stock goes in the wrong direction from the expected movement, making the trade unprofitable, a stop loss order helps minimize the loss.
How Does Stop Loss work?
An intraday trader assigns the stop loss level on her trade beforehand. When the cost reaches the predetermined stop loss level, the transaction automatically closes. The trader is able to save the rest of her invested money. One can begin preparing a plan for a return of the funds that were lost. Essentially, opting for a stop loss order prevents a bad trade from becoming worse, in terms of money lost.
How to Calculate Stop loss?
Let’s take an example to understand how stop loss would appear on a trade. Suppose you want to purchase a stock presently trading at ₹104, you must now determine where you want to place your stop loss. Keeping the stop loss under ₹100 at ₹98 is a good number to go for. This indicates that you are okay with losing ₹6 on this particular trade, however, any more than that will result in the transaction terminating.
Additionally, your target amount should be 1.5 times the stop loss percentage. In this case, the stop loss was ₹6, which you are okay with losing. Your minimum gain should, therefore, be ₹9, which would put you at ₹104 + ₹9 = ₹113.
Where to set my Stop Loss level?
Most beginner traders struggle to determine where to set their stop loss levels. If one sets her stop loss level too far, she runs the risk of losing a lot of money if the stock heads in the wrong direction. Alternatively, traders who set their stop loss level too close to the buying price lose money as it is taken out of their trades too soon.
There are various strategies one can use to calculate the amount of stop loss for each trade. These strategies can be watered down into three methods you can employ to decide where to set your stop loss:
- 1. Percentage Method
- 2. Support Method
- 3. Moving Average Method
Calculate Stop Loss Using the Percentage Method
The percentage method is commonly used by intraday traders to calculate stop loss. In the percentage method, all one has to do is assign the percentage of the stock price they are prepared to lose before exiting the trade.
For instance, suppose you are content with your stock losing 10% of its value before you exit your trade. Additionally, let’s say you own stock trading at ₹50 per share. Accordingly, your stop loss would be set at ₹45 — ₹5 under the current market value of the stock (₹50 x 10% = ₹5).
Calculate Stop Loss Using the Support Method
Compared to the percentage method, calculating stop loss using the support method is slightly difficult for intraday traders. However, seasoned intraday traders are known to use it. To use this method, you need to figure out your stock’s most recent support level.
An area of support is where the stock price often stops falling, and an area of resistance is where the stock price often stops rising. Once your support level is determined, you simply have to place your stop loss price point below the support level. Suppose you own stock currently trading at ₹500 per share and ₹440 is the most recent support level you are able to identify. It’s recommended to set your stop loss slightly under ₹440.
Both support and resistance levels are seldom accurate. Before pulling the trigger on it by exiting, it’s useful to give your stock some room to come down and then bounce back off of the support level. Setting the bar slightly below the support level allows you to give your stock some wiggle room before you choose to exit your trade.
Calculate Stop Loss Using the Moving Averages Method
The moving average method is easier for intraday traders compared to the support method to determine where to set their stop loss. First, a moving average needs to be applied to the stock chart. A longer-term moving average is better as it avoids keeping your stop loss too close to the stock price and being removed from your trade too soon. Once the moving average has been inserted, set your stop loss slightly below the moving average level, as it has more wiggle room to change direction.