How to set a stop-loss for your trades

Trend-following technicians are delighted at the current market situation. The Nifty has hit a succession of higher highs and this is ideal for trend-following. Every such system would suggest a version of the following: Stay long Nifty with a stop-loss below the entry price.

One of the conveniences of technical analysis is that the methods are scale-invariant across large time ranges. A short-term trend-following trader might look for three-session highs or lows; a long-term positional trader could look for 200-session highs/lows. If they're using moving average (MA)-based systems, some would use short-term MAs, while others would use long-term MAs.

Highly sensitive systems would have been triggered when the Nifty hit a 10-session or 20-session high (20 sessions is about a month in date ranges). Others would have been triggered by 55-session highs (three months) or even longer.

Trends are always more likely to fail than sustain. The shorter the time frame, the higher the chance of failures. Trend following works on the assumption that, every so often, a trend will sustain and return enough to over-compensate for several losses. Stop-losses are mandatory to prevent losses going out of control. Some stop-loss systems use 20-day lows, or 55-day, etc. These are popular but steep trends/ counter-trends can put a lot of money at risk before such a session-based stop triggers.

Other stops are geared to margin considerations. Say, the trader is comfortable losing up to 20 per cent of margin. If he's putting down a 15 per cent margin on a given contract, he should set the stop at roughly 2.5-3 per cent (allowing for slippage). A third stop setting method involves volatility calculations. The technician calculates the historic volatility of a given time period (a "true range" or average true range) and sets stops based on these.

The stop-loss must also be dynamic. It should be a trailing stop that changes as the position runs into profit. A trailing stop involves programming some mechanical instruction such as "move the stop-loss up one per cent if the price moves up two per cent and repeat" (this is for a long position). Setting those parameters is difficult. Subjectively speaking, some people are tempted to book profits early, while others refuse to book profits and hold a profitable position till it runs into losses.

One method is to set a continuously trailing stop, a fixed amount (or fixed percentage) below the price. In practice, this means either continuous monitoring, or programmed instructions, which recalculate and reset the stop at fixed time intervals, or at fixed price intervals. Most systems reset trailing stops on the basis of end-of-day prices.

There are lots of subjective considerations about individual risk-appetite to be taken into account before employing a mechanical trading system. But once the parameters are set, the system should take care of all the critical decisions.

The author is a technical and equity analyst