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The similarity of stake management methods in gambling and trading has often been remarked on. Both types of “games” involve betting on uncertain events. The principle is the same: When luck runs against you, good stake management will allow you to stay solvent longer.
The number of successive losses required to drive a gambler into bankruptcy is the risk of ruin. This is easy to calculate in a game like blackjack or poker where the gambler is dealing in multiples of a minimum stake. It is up to him not to do something stupid and bet large amounts on losing hands.
At trading, the risk of ruin equation is more complicated because the trader has much more control on the quantum of loss. He has to set the minimum stake by setting a stop-loss and, of course, he must be disciplined enough to accept the loss. Assuming you are not a day trader, you will not use mechanical stops because these require resets.
Where should a stop-loss be set and what kind should one use? Some traders set a ‘money stop’. That is, they are prepared to lose a maximum fixed amount per trade. Others use ‘percentage stops’ — the stop-loss is set at a fixed percentage away from the entry price. A third set uses stops set with reference to price-chart congestion points.
My personal feeling is the three systems, or any other system of stop-losses used, should align to give roughly the same numbers. Otherwise, the contract is probably not worth taking.
To manage stakes efficiently, taking risk of ruin into account, the trader must have a money stop. He cannot afford to lose, say, Rs 10,000 on one contract and Rs 30,000 on the next, without losing control of risk of ruin.
The money stop must be set at a fixed percentage of the trading corpus. It could be one per cent of corpus, or it could be five per cent. That is up to the trader's personal risk-appetite. Obviously, the smaller the cut-off, the better the risk of ruin.
A highly volatile stock, or a high-priced stock with a large lot size, will often see tight stop-losses being triggered even when the trade is right. This leads to unnecessary losses. A stop-loss must be placed at enough distance from the entry price to allow for some volatility.
For example, if you are taking a trade in a counter that usually swings four per cent a session, a stop-loss at 0.25 per cent from the entry price will be useless. So, the percentage stop makes sense. Any practical trader also knows price moves often halt when they hit congestion points. So, the chart-based stop also has logic.
If the percentage stop or the chart-based stop carry larger losses than the money stop, the contract is simply too ‘big’ to handle with the given corpus. If the percentage stop and chart-based stop are much less than the money stop, the contract may not offer large enough returns. The ideal contract is one where these all align.
The author is a technical and equity analyst
