Traders Edge Nifty 50 , Our Algo based advisory product, (Up 33.3% since July 2018 net of taxes and brokerage), showcases how the correct usage of stoplosses (apart from picking the right trades) can accumulate returns even within an overall directionless and volatile market. The optimal usage of a concept called Average True Range powers this product and can help you with your trades too!
There is no trader in the market who wasn’t right about what he or she said – and yet, there is virtually no trader in the market (that we know of) who has made millions!
The difference between the two? Inaccurate usage of stop losses!
There are lots of people who went short on the Nifty above 11500 and yet didn’t make money even as the Nifty travelled below 10,000 recently and vice versa as well. Why? Because stop losses were maintained arbitrarily without considering what would be a “good” level to stop out the trade. The stops were triggered, the trader exited and then the real anticipated large move came – but alas, the trader was out!
What Is a Stop Loss
One of the most common questions of a Trader is on setting Stop Loss. Where to set it and what are the ways to identify stop loss levels.
Stop Loss can be of two types; Initial Stop Loss and Trailing Stop Loss. This Stop Loss is kept as a risk management measure, should the trade go against the desired outcome of the Trader.
There are many ways to decide the Initial Stop Loss Level:
Hard Stop Loss
A hard stop loss is defined as the maximum risk a Trader can take. This is equivalent to the sum of money that one is willing to lose should the trade go wrong. So essentially, it is a notional value- based on a “mental” value. This method of setting Stop Loss is commonly used but not even remotely correct. While it may protect risk, it may lead to many more loss trades than what the trader should have suffered
Historical Volatility Based Stops
It is intuitively clear that it is better to have a technique to set the stop loss at levels which take into account changing volatility of the market. When the market is volatile, stop loss should be wide and when the market is less volatile, stop loss can be relatively less wide. One way to to calculate stop loss based on volatility is to calculate the Historical Volatility of the stock being looked at. The formula for calculating Historical Volatility is,
HV = StandardDeviation(Ln(close/yesterday’sclose), days) *100*Sqrt(number of trading days in year)
where, Days = Length of days (10,20,30,40 …. )
Ln = Natural Logarithm
For e.g A 50 Day HV with 252 trading days in an year would be calculated like this,
HV(50) = Stdev(Ln(Close/Yesterday’s close), 50)*100*Sqrt(252)
Once you have the Historical Volatility of the stock, you can simply subtract it from your entry price and you would get your stop loss.
ATR Based Stop Losses
Another popular way to keep a Stop Loss which takes into account stock’s volatility is with the help of ATR. ATR is the Average True Range of the stock over a period of days decided by the Trader.
The ATR is calculated simply as a derivative of the True Range- The range of a day’s trading is simply the difference between the High and the Low. The true range is the then the largest of the:
- Most recent period’s high minus the most recent period’s low
- Absolute value of the most recent period’s high minus the previous close
- Absolute value of the most recent period’s low minus the previous close
The ATR at the moment of time t is calculated by extending this range to n number of days (Visit https://en.wikipedia.org/wiki/Average_true_range for more on this).
The way to set a Stop Loss using this measure is to take the ATR(n) value and multiply it by a factor of 2 or 3. The most popular multiplier for shorter term traders is 2 and the most popular ATR setting is ATR (14). That is, Average True Range over a period of 14 days.
ATR is available in most Technical Analysis Softwares and therefore once you have the value of ATR, you can simply multiply it with the factor of 2 and subtract it from your entry price (in case of Buy trade) or the reverse if it’s a sell trade.
Example, the above chart of ITC shows the ATR at Rs 2.48 – for a 1 hour candle trader. It would therefore be prudent for a trader to put the stop loss around 2*2.48 = Rs 4.96 for long trades.
Since the ATR describes how much an asset typically moves over the course of the day, day traders can use this information for plotting profit targets and determining whether a trade should be taken on. Assume a stock moves Rs 3 a day, on average. There is no significant news today but the stock is already up Rs 4 – Assume this trader gets a buy signal from a strategy. While the buy signal may be valid, since the price has already moved significantly more than average, betting that the price will continue to go up and expand the range even further may not be a prudent decision. The trade is against the odds- the price is more likely to fall, staying within the price range already established. In this case, shorting is maybe a better choice though of course assuming a valid trade signal occurs – example reversal within the day’s R3 levels (3rd Resistance) or Bollinger etc.
Traders Edge Nifty 50 Stocks
Our trading advisory , TEA Nifty 50, product uses ATRs in conjunction with other proprietary indicators to define initial as well as trailing stop losses. Our performance on these derivative trades, which are limited only to the most historically profitable Nifty 50 constituent stocks, indicates that creative use of ATRs can substantially improve trading results. The stop loss moves continuously to reduce risk or lock in a profit. Learn more by mailing us at email@example.com on this product.
If you wish to subscribe to our Traders Edge Nifty 50 SMS advisory service, simply visit www.plindia.com/instapicks and subscribe to any of our packages.
You may of course also design your own backtests and trading strategies if you are a Prabhudas Lilladher client by asking us for a subscription to Fox Trader, our Algo terminals. Mail us at firstname.lastname@example.org for more on this.