For the health of your portfolio, apply measures like targets and stop-loss.
A good batsman adapts to different conditions and quality of opposition. On a flat wicket against weak bowling, he plays shots freely. If the conditions are against him and the bowling is good, the forward defensive stroke and the leave outside off-stump become most crucial.
By analogy, a trader has to be more careful and defensive in a bear market. The trading equivalent of the forward defensive is the stop-loss. You can sometimes get away without stop losses in a bull market though it’s always a good idea. In a bear market, trading without a stop loss is one way to commit financial suicide.
This is especially true if you hold long positions. By definition, a long strategy is against the odds when operating in a bear market because most stocks are moving down, most of the time. You can make money on the long side during the recovery and correction phases of a bear market. But those opportunities are fleeting and the trend is always liable to reverse and drop again. Even if you’re on the short side in a bear market and playing with the odds, a stop loss is very useful.
Most traders are appallingly ignorant and indisciplined about stops. So are most investors. Keeping a stop loss doesn’t mean giving a stop order (sell/buy) with a price limit. In fact, stop losses are very rarely about pre-set stop orders.
A stop loss requires working out your personal pain limit before initiating a trade and translating that into prices where you will cut your losses. If the stop-price is hit, you reverse the trade. If that stop price is not hit, you let the trade run and shift the stop loss as and when you go into profit. For example, if your position gains 5 per cent, you move the stop by 3-4 per cent to ensure locking in some profits while letting the trade run on for more.
By making those preliminary calculations, you also develop a better sense of the inherent risk:reward in the trade and the probability of it occurring. This can lead to further insights, including the likely time factor and that can help you fine-tune strategy and thought processes.
To take an example, say you believe Tata Steel is in a downtrend. So, you enter a futures trade putting down roughly Rs 23,000 as margin to sell each lot of 500 shares at Rs 460. You are prepared to lose around Rs 12,000.
Given 10:1 leverage and probable slippages, this translates into a 5 per cent adverse move. You tentatively set a mental stop loss at 485. To keep a positive risk:reward equation, you must be hoping for above 5 per cent return. Say, you set a minimum target of 425-430.
Are these realistic and what sort of time will be required? Look at volatility. In the past three months, Tata Steel has averaged high-low swings of around 2.4 per cent per session. It has a standard deviation (SD) of 1 per cent.
Hence, about 95 per cent of the time, the stock stays in a volatility range of 4.5 per cent (average + two SD ). There are other methods of calculating volatility (like Average True Range) but this mean-standard deviation method is very simple and we’re only seeking a rule of thumb here.
Your pain limit may take 2-3 successively adverse sessions to be hit, if the stock moves against you. On the other hand, for a successful trade, it will require at least 3-4 sessions in your favour. In practical terms, there may be several sessions when the stock doesn’t shift much in either direction.
You must be prepared to hold this short position for 10 sessions, given this pain limit and the associated mental stop loss and targets. There are only four sessions left till settlement. Are you prepared to rollover if neither the stop loss (785) or the target (730) is hit?
Should you decide not to rollover, you must reduce both your stop-loss and your expected targets to cater to the natural volatility of the underlying. Whatever you do, you should take the decisions before you enter the trade and not in the last 15 minutes of the August settlement. This is better for both your blood pressure and the health of your portfolio.
(Caveat: For what it’s worth, Tata Steel looks like a good short position. My target based on chart projections would be around Rs 440 within the August settlement. However, rather than a recommendation, the above is given as a practical example of how a trader should think.)
