Probability and the Art of placing Stop Loss

As I trade more and more I realize that I have difficulty in selecting the right stop loss level.

At first glance, the technical determination of a stop loss level seems to be rather straightforward. If you are going long, then the stop loss should be the last swing low or even the previous swing low. The difficulty of the situation is that sometimes the stop loss is so far away that it is scary to think of the possible loss.

Take for example the Nifty chart on the left. If you happen to go long between May 19 and 22, your stop loss should have been at 3675 and that is a good 600 points below!!

The important thing to realize is that not only you need to consider the amount of loss but also the probability of the loss being realized.

In other words, if the stop loss is set 50 points away and the probability of its getting hit is 10%, that may be better than setting a stop loss 10 points away where the probability of getting hit is 60% [[This is because 50 x 0.1 < 10 x.06]]. This means that all other things being roughly equal, a wider well thought out stop loss may work better in the long run.

This point is particularly relevant for day trading, A tight trailing stop loss may actually result in getting stopped out more often than what you anticipate ( this is precisely what is meant by high probability of the stop loss getting hit), resulting in large number of mini losses, all adding up to a big total.