Why setting a stop-loss is important

Since June 30, 2016, the Nifty is up by about 17 per cent while the Midcap 50 index is up by 32 per cent. In the 12-month period until June 30, 2017, foreign portfolio investors (FPI) pumped Rs 55,000 crore into Indian equity, while domestic institutions have contributed about Rs 48,000 crore to the bull-run. 

However, equity mutual funds may have contributed almost twice as much as FPIs and DIIs combined. Since June 2016, the assets under management of all equity-oriented schemes, including ELSS-equity and ETFs, have grown Rs 1.9 lakh crore. In addition, retail investors have put huge sums directly into stocks.

This is a rare situation of aligned attitudes. Where DIIs and FPIs are concerned, one group is usually selling when the other is buying. Retail investors have not bought equity in this manic fashion since 2007. What's more, the liquidity flowing into the market is likely to be enhanced if the Reserve Bank of India does cut rates.

In technical terms, there is only one thing for an index trader to do. That is to ride the uptrend until such time as the trend breaks. Various trend following systems would suggest staying long in the Nifty, with a trailing stop-loss. 

Where the stop-loss is placed is up to the trader who will have an individual risk: reward equation. One advantage to using either a moving average or an intra-day low as the stop-trigger is that the stop automatically changes to reflect trending moves. In an uptrending market, the stop will automatically move up and vice versa, it will fall in a downtrending market. 

A short-term trader may use a short-term moving average level as a stop-loss. Such a trader would be placing a stop somewhere between 9,950 and 10,000 since the 7-day moving average is at around 9,985. A trader who's looking at holding through the settlement might consider using the 20-Day moving average, which is around 9850, as a selling trigger. A position trader may look at the 55-DMA at 9,680. A trader who prefers using record highs and lows as triggers may use the 21-Day low of 9,450, or the 55-day low of 9,272. 

Obviously, each of these stop-losses sets up different risk: reward equations. The trader must be hoping to make profits that exceed the potential losses. For example, somebody using 9,950 as the stop-loss, stands to lose around 150 points or roughly 1.5 per cent. Given a lot size of 75 Nifty, this trader stands to lose a minimum of about Rs 11,000 for 1 lot. Presumably such a trader is hoping for a move of over 150 points in the Nifty.
 

Somebody using the 55-day low of 9,270 has a perspective of about three months (there are about 20 trading days a month). This trader could lose 8 per cent or about Rs 60,000 per lot. Presumably this trader must hope to gain more than 8 per cent. In other words, such a trader would be hoping for the Nifty to sweep to a minimum level of 11,000.

It’s up to the individual to understand the risk: reward equation and decide if the expected gains are realistic. It's absolutely imperative to keep some sort of stop-loss even if that stop is just a mental note to get out at a certain level. If the stop is hit, the trader should exit, in disciplined fashion, without any second-guesses. 

An index that has gained 6 per cent in the last month and 16 per cent in the last year could sustain similar losses just as quickly. If there is no stop loss, a trader could carry over a losing position indefinitely.