How to Calculate Stop Loss in Intraday Trading?
Trading in the stock markets can generate substantial profits. However, losses are also an inevitable part of trading. While trading in the stock markets, you must learn to manage the risks effectively, using appropriate tools and strategies. One such popular strategy involves placing a stop loss order along with your trade to put a cap on your maximum losses. This article provides insight into using stop loss in stock market - understanding how it works and how to calculate stop loss for your trades.
What is stop loss?
Each time while placing an order in the stock market, the trader is exposed to the risk of the market slipping away in the opposite direction. Suppose you are an intraday trader and place an order expecting a bullish movement. However, the stock suddenly takes a hit when you place the order and starts plunging. Since intraday trading requires you to square off your orders on the same day, you may not have sufficient time to wait for a trend reversal. A stop loss helps you to exit a wrong or miscalculated trade by incurring reduced losses.
How does stop loss work?
A stop loss works by squaring off your order when prices reach a certain predetermined level. Therefore, it is an effective tool for cutting your losses. Fixing a specific stop loss value ensures your maximum loss cannot exceed the limit you have set. As a result, a stop loss helps prevent a bad trade from worsening.
How to calculate stop loss?
Suppose you place an intraday order to purchase 100 shares of a company at Rs. 150/share. You believe the stock will go above Rs. 160, driving your profits. However, you are worried that the stock might move in the other direction, and you would lose considerable money from this trade. How do you protect yourself from making losses? You set a stop loss order at a fixed value until where you can bear the losses. You analyse you can handle losses if the stock goes down to Rs. 140, but anything below that would drastically impact your holdings. So, you plug in a stop loss order at Rs. 140. This means that if the stock prices fall to Rs. 140, your long position will be squared off automatically and prevent any further losses.
Scenario 1: Stock price moves up to Rs. 160 -
Your analysis was correct, and you make profits worth Rs. 30/share and the total profit becomes Rs. 1,000.
Scenario 2: Stock price dips to Rs. 140 -
You incur losses. However, since you have already placed a stop loss order at Rs. 140, your maximum loss gets confined to Rs. 150 - 140, i.e., Rs. 10/share, and the total loss becomes Rs. 1,000.
Where to set my stop loss level?
Although stop loss is an excellent way to minimise losses, traders often face a dilemma of how to set stop loss. One of the most critical factors that determine the success of a trade is identifying the right stop-loss level. If the stop loss order is set to close to the order value, small price fluctuations may set it off, and your position would get squared off immediately. You can determine your stop loss level using multiple techniques, such as the percentage method, support method and moving averages method. Let us understand these in greater detail.
Calculate Stop Loss Using the Percentage Method
The percentage method is one of the traders' most widely used techniques to determine their stop loss levels. The trader assigns the maximum permissible loss using a percentage. Suppose you would be all right if the stock price falls to 5% of its current value before you exit your trade. You purchase a stock currently trading at Rs. 500. Your stop loss will be set at Rs. 25 or lower, i.e. at Rs. 475.
Calculate Stop Loss Using Support Method
The support method requires you to understand technical charts' support and resistance levels. The support level is the maximum level up to which stock prices can fall in an interval. Since this is the lowest value that stock prices attain, the support level is called the demand zone. The resistance level is the maximum level until which stock prices are expected to rise. While placing a buy order, it is recommended that you place your stop loss slightly below the support level, and in the case of sell orders, the stop loss can be placed a little above the resistance level.
Calculate Stop Loss Using Moving Averages Method
The moving averages method is a simple way of determining your stop loss. During this method, an indicator 'moving average' is applied to the stock's charts. The moving average is a line that runs along the stock price. You can plug in your stop loss a notch below the moving average line. However, keeping a buffer is recommended so your position does not get squared off with the slightest of volatility.