Demystifying Derivatives: Importance of Stop Loss

In our Demystifying Derivatives blog series, we have explained the basics of how futures and options (F&O) work. We have also discussed the risks in derivatives trading and margin requirements. In my interactions with retail investors over the past decade, I have seen that, investors, who trade regularly in the market, are mostly interested in stock tips, buy price, sell price, support level, resistance level etc. In my opinion, these are not the most importance facets of trading and investing.

I think the two most important aspects of trading are, knowing your risk capital and loss protection. If you do know about risk capital and loss protection, you should not be trading at all. We discussed about risk capital and its importance in our post, Demystifying Derivatives: Margin for options contract and Risk capital in F&O. In this post, we will discuss about the other important aspect of derivatives trading, loss protection.

No one likes to lose money. But equity markets are volatile and will not always move in the direction we like. If the price at which you buy derivatives is more than the sell price, you will make a loss. You should understand the difference between marked to market loss and a permanent loss. A permanent loss (or profit) takes place when you square off your position (squaring off means that, you sell if you had bought derivatives or buy if you sold derivatives).

In derivatives, you have to square off your position before the expiry of the contract, which, as discussed earlier, takes place on the last Thursday of the series for the month. If you do not square off positions before expiry, they are automatically squared off on expiry and are adjusted against your margin.

Why is loss protection important in derivatives?

We had discussed earlier that, in derivatives, the size of your position (buy or sell) is usually much bigger than the money invested by you (known in finance parlance as leverage) and therefore, the loss can also be quite big. Let us understand, with the help of an example. In derivatives, by investing र 1 lakh, you can take a position of र 8 lakhs. If you had invested र 1 lakh in stocks or mutual funds and the price fell by 10% in one month, your loss would have been र 10,000 but in derivatives your loss would be र 80,000 (10% X र 8 lakhs) and most of your capital would be wiped out. Remember, in the case of derivatives, the loss is permanent and therefore, you have less money to invest in the future. The less money you have, the less money you can make.

Regular readers of our blog know that, if you stay invested longer, you can make more money because equity as an asset class gives superior long term returns. However, big losses impair your ability to remain in the market. Therefore, loss protection is very important.

Losses cannot be totally avoided but can be limited

We had discussed about the Random Walk Hypothesis in our blog. As per the Random Walk Hypothesis, it is not possible to predict equity prices accurately in the short term. Therefore, you cannot prevent losses, but you can definitely limit your losses. While astrologers can have a different viewpoint, simply going by the laws of probability, you cannot remain unlucky forever and therefore, if you stay in the market long enough, you have a chance of recovering losses and making money. If you can limit losses in trades, you can stay in the market longer and possibly recover your losses and make money. That is what professional traders (both domestic and FIIs) do and they do make money; otherwise they would not be in the market. How do you limit losses in trade? There is a simple and methodical way of doing it, which most retail investors do not follow and that is why they make bigger losses in their risk capitals. You can limit losses by using a stop loss order.

Stop Loss Order

A stop-loss order that you can place with your broker, either online or on the phone, whereby you instruct the broker to automatically reverse you position if it drops/rises to a certain price. When you are trading with stop losses, you have to specify a price, when the trade gets reversed automatically by the broker without your interventation. If you are trading online, you can input your stop loss, when you initiate the trade. For example, you want to buy one lot (1,000 shares) of stock futures at र 1,000 expecting price to go up by र 100 during the month.

However, if instead of rising, the price falls, you will make a loss. You should determine upfront, how much loss that you are willing to take? Let us assume that, you put in a stop loss order at र 970. If the price goes to र 970, the futures will automatically sold by your broker and your loss will be र 30 per share. Your total loss will be limited to र 30,000 (र 30 X 1,000).

Let us assume your margin was र 100,000. The loss will be adjusted from your margin and you will be left with र 30,000. If you do not place a stop loss order and if the price falls to र 950, then your loss will be र 50,000 and you would be left with only र 50,000 of capital.

With stop loss, you are essentially protecting your capital and you will have substantial capital left with you, even in the event of unfavourable price movements. You can use this capital to take fresh positions and if the price movement is favourable, you can recover your losses and make some money. On the other hand, if you do not have stop loss and lose a big part of your capital, you will have not sufficient money for a fresh trading position and therefore, not be able to recover the loss. The concept of stop loss is extremely intuitive and simple to understand; yet many retail investors trade without stop losses. This may be due to lack of knowledge, but there are behavioural factors also at play that prevent investors from putting a stop loss order

The behavioural aspect

We have discussed a number of times in our blog that, greed and fear are primary emotions in short term trading and investing. We do not like losses and I admit, accepting a loss is difficult. When we trade, we expect to make a profit. Even if the price goes the other way, we keep hoping that the prices will eventually turnaround. This hope prevents us from accepting a loss and booking it; however, this can lead to a bigger loss. Some traders may tell you that, a stop loss order will prevent you from making money. Let us revisit the example discussed earlier. You want to buy one lot (1,000 shares) of stock futures at र 1,000 expecting price to go up by र 100 during the month. Let us assume, the price goes down to र 960 and rebounds to र 1,030 by expiry. If you had placed a stop-loss order at र 970, you would have made a loss of र 30,000. But if you did not have a stop loss in place, you will make a profit of र 30,000.

But does this justify, not having stop loss? No, because, as per Random Walk Hypothesis, it is not possible to predict short term stock price movement. The price, instead of rebounding from र 960 to र 1,030, could have gone down to र 920 also and you would have made a bigger loss. If you do not have stop loss in place, you are simply relying on luck, which can be dangerous in stock markets. Knowing when to book a loss is very important in trading and investing. Successful investors make money, not because they are incredibly lucky, but through discipline, process and knowledge. Stop loss takes the emotional aspect out of derivatives trading and helps you stay disciplined. However, stop loss should not be arbitrary; you should follow a method to put stop losses.

Where to put a stop loss?

You can follow three methods to put a stop loss order:-

1. Percentage Method:

   In this method, you should determine the percentage loss that you are willing to accept, should price movement be unfavourable. For example, you are comfortable accepting a 10% loss. Your margin is र 1 lakh, futures price is र 500 and your exposure is र 10 lakhs (2,000 shares). Since your loss limit you can accept is र 10,000, you will place your stop loss at र 495 (र 5 loss per share X 2,000 shares = र 10,000). Remember, you can also short (sell) futures. If instead of buying futures, you were selling it with the expectation of price going down you will place your stop loss at र 505. When placing your stop loss order, you should not place your stop loss too far from the buy/sell price because, in that case, you can make a big loss. On the other hand, you should not place too close to the buy/sell price, because in volatile market like ours (in India) the stop loss can get triggered simply by the normal volatility (without any definitive price trend).



2. Support / Resistance Method:

   In this method, you will set the stop loss at support or resistance levels, depending on whether you are long (buying) or short (selling). We had discussed about support and resistance levels in our technical posts, but for the benefit of readers who have not read those posts, these are levels from which prices reverse after moving in a particular direction. If price is falling, it is expected to stop falling and start rising when support level is reached.
   
   Similarly, if price is rising, it is expected to stop rising and start falling when resistance level is reached. We have discussed how to determine support and resistance levels in our technical analysis posts, Support and Resistance levels: Technical resistance for Nifty at 8000 to 8100 and Where will the stock market bottom out: A technical perspective.
   
   If support levels are breached, then, as per technical analysis, prices can go much lower and you can make big losses if you are long (buying). Similarly if resistance levels are broken, then prices can go much higher and you can make big losses if you are short (selling).
   
   In our post, Demystifying Derivatives: Basics of Futures and Options Part 1, we had said that, good knowledge of derivatives can help you understand capital market behavior, whether you are trading in F&O or not. You may have seen that, once a support level is breached, the price falls sharply. This is because many professional or FII traders set their stop losses at support levels, and once they are breached, stop losses are triggered. When stop losses of professional or FII traders are triggered, large volumes are sold and the prices fall sharply. Similarly, once resistance levels are broken, stop losses of traders who have short positions are triggered. This is known as short covering and you will see prices rising sharply. If you are setting your stop losses at support or resistance levels, you should not set them at those exact levels but slightly below (for support) or above (for resistance), so that you have some wriggle room, because as discussed earlier, prices can reverse from support or resistance levels.



3. Moving Average Method:

   This is a simpler method than the Support / Resistance method, because there can be multiple support or resistance levels for a stock or index. On the other hand, there are defined short-term or long-term moving averages for stocks or indices. We have discussed moving averages in our technical post, Where will the stock market bottom out: A technical perspective.
   
   For beginners in technical analysis, daily moving average (DMA) is an easy to understand concept. DMA, as the name suggests, is the daily moving average of the asset prices over a certain rolling period. For example, the 30 DMA of Nifty is the daily moving average of Nifty over the last 30 days. For placing stop losses, you cannot rely on very long term moving averages like the 100 or 200 DMAs. Those DMAs take a long time to get breached and you can make substantial losses, which will defeats the purpose of stop losses. On the other hand, a 5 day moving average (DMA) can easily be taken out in course of normal volatility in the market. There is no magic DMA period that traders use for stop losses; it depends on the market conditions. Many professional traders use 10 / 15 DMA to place stop losses. Depending on your risk appetite, you can also place your stop loss at 30 DMA.

Conclusion

This series on Demystifying Derivatives, our objective is neither to encourage F&O trading nor to dissuade you from it. Our objective is to increase your knowledge of these complex instruments and the various facets of derivatives trading, so that you can decide whether you want to trade in F&O or not; more importantly, given the importance of F&O in our stock market, good knowledge of derivatives can help you better understand the behaviour of the market in the short term. In this post, we discussed the importance of Stop Loss in derivatives trading. In upcoming posts, we will discuss other aspects of derivatives trading and how it impacts our capital market. Please stay tuned.