Setting a stop-loss that suits your risk appetite is important

A new 52-week high is a strong trending signal. If it accompanied by higher than normal volumes, it is even stronger. When such a signal shows up in a stock, the trader has to go long. He also has to use a trailing stop-loss. He is hoping the breakout will lead to a substantial move and he wants to capture as much of the gains as possible. The stop-loss has to be calibrated as to allow the trade to continue in case of “normal” reactions after breakout, while being good enough to cut the trade in case of trend failure.

There are several methods of setting initial stop-losses. One is to simply set the previous 52-week high as the stop-loss. This works if the new high is substantially above the previous one. However, if the new high is close to the previous one, the stop-loss could be too tight. Another method is to set the initial stop-loss at the low of the day on which the breakout occurred. Again, if the breakout came with an upwards gap like an opening upper circuit, this doesn't work.

A variation on this method is to set the stop at the low of the previous 10 or 20 trading sessions. This is better than the single session low. But it could be a very loose stop-loss if there's been a strong uptrend prior to breakout. It's perfectly possible that in such cases, the stop-loss could be 15-20 per cent below the entry price and this might lead to unacceptable losses.

Chart-based methods of setting stop-losses also exist. For example, the trader might read the price-chart and note that there’s been congestion at some level below his entry point and use that as a stop loss. Or he might use some variation on a short-term Fibonacci calculation and set a stop-loss at indicated retracement levels. One problem is that chart-based stops cannot be easily mechanised.

More methodical ways to set a stop-loss involve trying to calculate likely volatility and to match that to the trader's own risk-appetite. For example, many traders use the Average True Range (ATR) calculation, one measure of recent volatility. Then a trader could set a stop-loss at some multiple or sub-multiple of ATR.

For example, if the ATR is say, 1.5 per cent of the entry price, the trader might set his stop-loss at the entry price less three per cent (2x ATR). This would imply he is prepared to stand the price moving against him for two average adverse sessions.  There’s no perfect way to set a stop-loss. Any method has drawbacks and all methods must take the trader's own risk appetite and preferred time frames into account. Learning how to set stops that suit your personal style is important and you must put time and trouble into this.
The author is a technical and equity analyst