How to set stop-losses on trading bets

Trend following boils down to looking for patterns of higher highs or lower lows, and betting that such a pattern will continue. The rest of it is about risk management in the form of setting stop losses and filters to ensure that the risk:reward ratio is positive and the patterns yield enough profits to make them worth trading.

The last four weeks have confirmed a strong downtrend by whatever indicators you use. We have seen lower highs and lower lows. There have been higher volumes on sell-offs indicating that the supply is increasing. The Nifty and other major indices are way below their long-term and their short-term moving averages.

Breadth indicators point the same way. The advance-decline ratio has been strongly negative. The broader indices have lost more ground than the Nifty. Losses have been spread across sectors, with information technology the only gainer. The number of 52-week lows far exceeds the number of 52-week highs.

A trend following style suggests shorting the market, with a trailing stop-loss. A pure trend following method does not set explicit targets. It simply holds the short, and moves the stop-loss down as the position becomes profitable. The trade ends when the stop-loss is hit. This could involve many months of rollovers.

However, the act of setting a stop loss implies a target since one is looking for a positive risk:reward ratio. Where does one set the stop-loss in this instance? One method is to set it at a 20-day high or a 50-day high, that is, 5,861 or 6,093, respectively. Assuming it's set at 5,861 here, the trader is prepared to lose 500-odd points. This implies he is hoping to make more than 500-odd points - that is, an index falling below 4,900. Given the likely carryovers, he is hoping for an implicit target of 4,800 or lower.

Other methods exist. For example, a simple look at resistance levels and breakouts, suggests the Nifty could have a downside till 5,150 in the near term while it could bounce till 5,600. If we use these levels as initial targets and stops, the risk:reward is slightly positive.

Another method is using Fibonacci retracement calculations. The bull market started in June 2012 at around 4,770 levels and peaked in May 2013 at 6,230. There has already been a 60 per cent retracement of the bull run. The levels of 5,325 may be the next Fibonacci support, with the next support coming at 5,085-5,100. A trader could use the 5,100 level as an initial target. In that case, he is looking at an initial profit of 200-300 points and must set his stop accordingly to keep a positive risk:reward ratio.

There are multiple ways of setting stop-losses. Whatever method you may use, definitely set stops. This is extremely important in the context of trading in a falling market where you will be leveraged and short.

The author is a technical and equity analyst