Author: thetrader

One of the questions that I often come across is, “How to place a stop loss? What should be the maximum loss that I should take before closing the position in a losing trade?“

Money management is one of the most important skills that a trader should possess in order to become successful in the stock market. Stop loss is what helps us in managing our capital in an efficient way. Proper money management ensures that one can take multiple Trades without wiping of our entire capital.

You should always make sure that the maximum loss you should take in a single trade should not be more than five per cent of your capital. So if you are starting with a capital of 10000 Rupees, you should not lose more than 500 rupees in a single trade. Similarly, if your capital is 100000 rupees, you should make sure that you do not lose more than 5000 rupees in a single trade.

The initial capital will vary from person to person so would the maximum loss that a person can take. If you follow proper money management, you can take 20 trades at a time. I do not suggest you take 20 trades at a time, I am just pointing out that you should be wrong 20 times to lose your entire capital.

What if you did not follow money management with a maximum 5 % stop loss? You let your losses run huge and maybe after 4-5 wrong trades, your entire capital will be wiped out. Let us learn to place a proper stop loss and preserve our capital.

Once you have decided how much maximum loss you as a trader can take in a single trade, now you have to decide the quantity that you can buy or sell. How can you decide the quantity? Quantity would be nothing but the maximum loss you can take divided by the maximum loss per share that you have decided based on your analysis of support, resistance, EMA, 200 EMA, trend lines etc.

Suppose ITC is trading at 200 rupees and has strong support at 198 rupees. You are hopeful that ITC would not breach 198 rupees level on the downside. This can act as good support and your stop loss could be placed below 198. That would be a stop loss of 2 Rupees per share.

A person with an initial capital of 10000 can lose a maximum of 500 if 5% rule of money management is kept in mind. The trader has also noted that he can place a stop loss of 2 rupees on a buy trade in ITC. So the trader can go into the buy trade with 250 quantity.

Similarly, if a trader has an initial capital of 100000 rupees, he can go into the buy trade in ITC with 2500 quantity.

Futures and options are derivative products. The value of the derivative product is determined by an underlying asset. The underlying asset can be stock, index or commodity. We will restrict the discussion to the equity market as the aim of the blog is to give a clear understanding of options and how good is option buying. Those who have some idea of Futures and options would find this blog really helpful. If you are a beginner, and interested in learning about futures and options, I would urge you to go through these two posts and return to this post later.

1. What are options?
2. Value of options.

We would learn about options from an option buyers standpoint in this post. We would cover option selling in a later post.

When would you want to buy a stock or an index option

A. We can buy an option when we want to trade a directional move 

After some analysis, you feel nifty can show a sharp up move and you want to make some gain out of the would-be movement. What are your options? We would restrict ourselves to buying option. You know you have to but a Call option. Let’s see this chart for our test case.

Let us go for buying a call. Here we have three choices, buying deep in the money call option, buying at the market call option and buying out of the money call option. All these scenarios are analyzed and we see that all these turn profitable. We can clearly see that choosing the best strike price has the potential to affect your profitability. Although when one buys deep in the money option, he pays less for the time decay and pays mostly for the intrinsic value of the option. Small reversals do not affect the Profit and loss in such a position. You can go through this blog to understand time decay and intrinsic value.

B. We can buy an option when we want to hedge a cash Position

Let us understand this with an example. Suppose you are very bullish on ITC in long term. You have bought 3200 shares of ITC at an average price of 200₹. You sense that in short term ITC may correct by 20 per cent, and it might go to 160₹ per share. In spite of that, you don’t want to exit the cash position since there is always a chance that it might not correct much and maybe rally up.

In such a case, you can still protect your holdings against the suspected correction of 40₹. This can be done by buying at the Money put or Deep in the Money Put. Note that the Put option can be bought in multiples of lot size. Right now the lot size of ITC is 3200 and one lot of ITC put can help in hedging 3200 ITC shares. We can buy ITC Put of 200 strike price and we are protected against any downside in ITC beyond 200₹.

If the ITC closes at 170₹ at end of the contract period, you can make a gain of 96000 (minus the premium paid) in Put option. Though you will see the value of the holdings of ITC has decreased by 96000, but you have not exited the holding value and booked no loss in it. You can still close the holdings position at 170₹. In such a case you will end up making no loss as the gain in the put option is same as the loss booked in cash holdings. This way we can hedge our positions in cash segment.

C. We can buy an option when we want to hedge a Futures position

This is similar to hedging a cash position, except that we have gone long in futures and bought the Put option to hedge long position. Suppose you are very bullish on ITC and bought one lot of ITC futures. The average buy price is 200₹. You sense that the price can dip a little in the next few days. You can either exit with a predefined stop-loss or hedge the position by buying at the money or in the money put option of a suitable strike price. Any loss in futures position will be covered by put option. In case of upside, the gain would be ideally infinite. So you can make a limited loss, unlimited gain strategy using this.

D. We can buy an option when we want to hedge an option sell/short Position

We can sell options as well. You can read more about prospects of options selling here in this blog. Options selling requires good capital and money management skills. If one is not active enough, the losses can be infinite. To protect yourself against infinite loss, you can buy an option too. This will ensure that the loss is finite.

ITC has been trading rangebound for quite some time. We suspect that it cannot go any lower than 200₹. We can sell PUT option of strike price 200₹. We can track trading price live at NSE website here. Suppose 200₹ strike price PUT is trading at 1.2₹. If we sell this option, we get a credit of 3840₹. This credit amount is product of lot size and trading price.

Maximum loss in selling this option is almost 6,40,000₹ if ITC price goes to zero. if we do not want to take a risk of 640000₹ to gain 3840₹, we can buy a PUT option of lower strike price in this case. One can buy 190₹ strike price Put option and limit the losses. We can make various options strategies using buy and sell combinations. Although option selling has a higher probability of success, it comes with a risk of huge losses. We can limit these losses by buying an option.

We will be updating this section with stock for the month for swing trades. It will also explain in detail the reason for picking it and risk to reward ratio. We will also upload an excel sheet with returns and loss updated and other details, which will in a way act as a trading journal.

Monthly Pick