Control risk by setting stop losses

The stop loss will depend on the risk appetite. If the system can afford more number of losing trades, chances of profiteering are better

Successful trading requires an understanding of concepts like odds, risk:reward and the risk of ruin. The selection of suitable contracts must be built upon these basics. A brilliant stock picker will lose money in the long run if he trades without heeding these, while an average stock picker who tailors systems to fit these basics may be highly successful.

The probability of the price of a given contract moving in a given direction is roughly 50 per cent. There is a small probability the price will stay static and there's brokerage. Say, the odds are roughly 48:52 against any randomly selected trade being profitable - that is, the price moving far enough in the chosen direction to cover brokerage costs. A good trader seeks higher predictability by tracking news, looking at charts and analysing fundamentals, etc. But predictability rarely shifts very far away from 50:50.

The stock market does often offer favourable risk:reward equations where the potential payoff or reward, is much higher than the potential loss, or risk. The key is that risk can be controlled via stop losses.

The set stop loss limit depends on risk-appetite. It could be say, Rs 1,000 for a conservative trader, or Rs 5,000 for a risk-taker. In practice, good traders will set a maximum limit and set stops to suit specific contracts such that the maximum is not exceeded.

Good trading systems tend to be developed around the one thing the trader controls, which is the loss. The potential reward must exceed the stop loss limit. The trader also needs to understand the risk of ruin: how many successive losing trades can be made before the trader is ruined? The more the potential number of losing trades the system can afford, the better the chances of profits.

Assume a corpus of Rs 1 lakh. Futures positions or day-trades require margins ranging upwards of about Rs 30,000 per lot. This means the trader will be knocked out of the market if he loses a total of Rs 70,000 or so.

The risk of ruin with a corpus of Rs 1 lakh is, therefore, 70 successive losing trades with a loss limit of Rs 1,000, and 14 losing trades with a limit of Rs 5,000. In practice, losses plus brokerage will always exceed stops.

The set loss limit, say Rs 5,000, may be translated to percentages. For example, trading a stock with a price of Rs 150 and a lot of 2,000 shares, a stop loss is triggered on an adverse move of Rs 2.5, or about 1.7 per cent. Trading a stock priced at Rs 1,100, with 500 shares per lot, it is triggered by an adverse move of Rs 10 or just under 1 per cent. Trading a stock priced at Rs 40 with 4,000 shares/ lot, the stop loss will trigger at 3.1 per cent.

The trader must pick contracts with lots, prices and historic volatilities that fit with preferred loss-limits. This is where good judgement and discipline is involved. If the trader picks a very volatile stock, or one with a very high price and lot size, the stop could be triggered by a small twitch, even for trades made in the right direction. If he picks a very low volatility stock, he won't make much. Trading discipline lies in identifying and sticking to suitable contracts and ignoring temptations that don't fit with the system.

There are more complications, of course. Most traders hold several positions at the same time and need a sense of total exposure. How much margin is deployed? How much could be lost if all stops are triggered? How strongly correlated are all held contracts? There are multiple ways to calculating volatility, correlation and exposures.

Finally, trades using options may have odds differing widely from even money. A deep-out-of-money option has a very small chance of success. But the reward to risk equation may be really tempting.

For example, consider a strangle of Nifty long near-month puts and calls with strikes at 10 per cent away from money. The Nifty has moved 10 per cent or more in a month, just 11 times in the past six years. That means there's roughly 1:6 chance of either option being struck. However, the payoff for such positions, when struck, is usually well over 10:1. Often, it is over the threshold of 13:1. So this method will come off rarely. But it may work often enough to make a profit.

All this sounds simplistic. But even experienced traders often fail to take the basics into account. Those who always do tend to be the ones that are successful in the long run.