How to Calculate the Stop Loss Level A Basic Guide

Two aspects matter to a trader — the return and the risk. All traders focus on the former, but only a few of them factor in the latter. Risk management is a crucial aspect of trading, and overlooking its importance can lead to significant losses that could reduce your profits at best or wipe out your capital at worst. 

Wondering how you can manage and limit the risk in your trades? The answer lies in setting a stop-loss. In this article, we discuss what a stop-loss limit is, why it is important, how to calculate the stop-loss price for your trades and more. 

What is a Stop-Loss Level and How Does it Work?

A stop-loss level is the price at which your trade is automatically closed to limit your losses. It is generally set in the opposite direction of the expected or prevailing price movement. 

For example, say you hold a long position in a company whose shares are currently priced at Rs. 150 each. You purchased the shares of this company at Rs. 140 each. The stock price is rising, and your position is growing increasingly profitable. However, if the price falls below Rs. 140, your profits will turn to zero and your losses will start mounting. 

You can cap the losses in this case by setting a stop-loss limit. For instance, say you set the limit at Rs. 130. This means that if the price reaches the stop-loss level, your position is automatically closed, limiting your losses to Rs. 10 per share. 

This is one of the simplest use cases of a stop-loss limit. However, you need to understand how to calculate the stop-loss based on your preferred risk-reward ratio. If you close a position too soon, you may miss out on potential opportunities if the market bounces back. If you set a stop-loss that is too low, your losses may grow significantly. So, to ensure that you close the trade at optimal levels, you need to understand the different stop-loss formulas that traders use. 

How to Calculate Stop-Loss? 

The example mentioned above is only one of the ways to calculate the stop-loss and use it to curtail your risk. Let us take a closer look at how you can use the different stop-loss calculation formulas to your advantage. 

• Stop-Loss as a Fixed Amount

This method to calculate the stop-loss works if you can only risk a fixed amount. It is a straightforward method that does not account for the stock’s price volatility. The stop-loss formula in this case is:

Stop-Loss Price = Entry Price — Fixed Risk Amount 

For instance, say you buy 100 shares at Rs. 100 each (total investment of Rs. 10,000) and can afford to risk a maximum of Rs. 1,000 on this trade. In this case, it means you can, at most, risk Rs. 10 per share. So, the stop loss price will be Rs. 90 (i.e. Rs. 100 — Rs. 10). 

• Stop-Loss as a Percentage

Here, you measure the amount of risk you can tolerate as a percentage of your capital. It is a more flexible method that adjusts according to the stock price. So, the stop-loss calculation formula in this case will be as follows:

Stop-Loss Price = Entry Price — (Entry Price × Stop-Loss Percentage)

Take the same example as mentioned above. You buy 100 shares at Rs. 100 each (total investment of Rs. 10,000) and can afford to risk a maximum of 5% of the investment on this trade. So, the stop-loss price will be Rs. 95 (i.e. Rs. 100 minus 5% of Rs. 100). If the price falls to Rs. 95, you will incur a loss of Rs. 500 and your trade will be closed. 

• Stop-Loss Based on Support and Resistance Levels

In this method, you use technical analysis to find or calculate the stop-loss using the support or resistance prices. The support level is the price below which a stock’s price does not fall. Rather, at this price level, it bounces back upward. Similarly, the resistance level is the price above which a stock’s price does not rise. Instead, it reverses downward at this level. 

While there is no specific stop-loss calculation formula as such, you need to decide how much above or below these levels you wish to close the trade. Here is how you can set the stop-loss limits using support and resistance. 

• For long positions, the support level is important because if the stock’s price breaks out below this level, your losses could mount. So, set the stop-loss at 1% to 2% below the support level. 
• For short positions, the resistance level is important because if the stock’s price breaks out above this level, you will start incurring losses. So, set the stop-loss at 1% to 2% above the resistance level. 

• Stop-Loss Based on the Average True Range (ATR)

The Average True Range (ATR) is a technical indicator that measures a stock’s price volatility. This makes it crucial for the stop-loss calculation formula because the level at which you decide to limit the loss depends on how volatile the market is. 

The stop-loss is typically set at a multiple of the ATR below the entry price for long positions and above for short positions. You can use this stop-loss formula if you know the ATR:

Stop-Loss Price = Entry Price — (ATR × Multiplier)

Here, the ATR multiplier is chosen based on your risk tolerance and the stock’s overall characteristics. Common values range from 2 to 3. Lower multipliers mean tighter stop-losses and higher chances of being stopped out, while higher multipliers allow for more price movements. 

• Stop-Loss Using Chart Patterns

In this method, you identify specific chart patterns and set stop-losses based on key levels within these patterns. While there's no universal formula, here are some common approaches:

• For a head and shoulders pattern, you can place the stop-loss just above the right shoulder
• In a double-bottom pattern, you can set the stop-loss just below the second bottom
• For an ascending triangle, you can place the stop-loss just below the lower trendline or the upper trendline, depending on your risk tolerance

Conclusion

Understanding how to calculate a stop-loss level is essential for effective risk management in trading. It helps you protect your investments from significant losses by automatically closing your position when the market moves against you. By applying various methods like fixed amounts, percentage-based or technical indicators, you can tailor your stop-loss to fit your trading strategy.

Using a tool like Motilal Oswal's Research 360 can further enhance your risk management techniques. Research 360 offers access to detailed technical analysis, real-time market data and customized alerts, which can help you determine optimal stop-loss levels. With these insights, you can make more informed trading decisions and manage your risk more effectively.