Strategies to maximise trading profits

Eight Nifty stocks hit 52-week lows on Monday. Another eight are within five per cent of their respective lows. Nine stocks in the Junior hit 52-week lows as well, along with another six within five per cent of respective lows.

A trend-following trader would be looking to short some of these in the stock futures segment. Stock futures are leveraged at roughly 15 per cent, hence a 15 per cent swing will offer 100 per cent gain or loss. The leverage makes stake management very important for derivatives traders.

How does one fine-tune for the ideal contracts? The best way to start is by eliminating contracts, which could lead to unacceptably high losses. This is like staying out of a poker game where the stakes are too high for comfort.

Any futures trader will lose money about half the time. Making an overall profit involves limiting losses while maximising gains. Stocks have individual levels of volatility and the losses or gains are dependent on that volatility. A stock that swings five per cent on an average day will lead to more gains or losses than a stock that swings two per cent per day.

The market lot tells you what the potential loss or gain is for every rupee change in price. A market lot of 2,000 shares for instance, means a difference of Rs 2,000 for every Rs 1 swing. Another important variable is recent historical volatility.

How much does the stock swing on a daily basis? Many traders use versions of Average True Range (ATR) calculations, a formula which considers the previous session's closing price, as well the high-low range. Some day traders average the daily high-low range of, say, the past 20 sessions. The ATR is more useful for overnight positions, since stocks often open with a gap but either method is reasonable.

If you are a day-trader, assume you could lose at least half the average daily range multiplied by the market lot. That is, if the average daily range is Rs 8, and the lot is 2,000 shares, you could lose at least Rs 8,000 in a session.

Most trend-followers are not day traders and, therefore, cater to overnight swings. As a rule of thumb, a trend-follower should budget for a possible loss of 1.5 to two times the average daily swing on overnight positions. If this level of loss is unacceptably high, avoid that stock.

You can also use this rule of thumb calculation to equalise stock position sizes in terms of risk. Say, stock A could see a potential loss of Rs 15,000/session while stock B has a potential loss of Rs 5,000/ session. Then, stock A is three times as volatile as B and, hence, an exposure of three market lots in B will carry the same risk as one lot of A.

Keeping an error margin on such calculations is necessary. Even if you are extremely disciplined about stop losses, prices can move very fast in either direction and there are no circuit filters for stock futures. However, allowing for error factors, these basic calculations are still helpful in comparing stock positions in terms of possible risk and reward.

The author is a technical and equity analyst