M3: Making sense of Stop Loss
In earlier model M2, we saw the outcome for different payoffs like 40% & -20%, 60% & -40%, etc. With built in human behavior (specifically as discussed in prospect theory), whenever we see profits, we prefer to cash in. And with looses we hold on and think market will revert and reduce the loss. Suppose, we start taking profits whenever we see gain of 25% & allow the looses to run, this is what happens:
| Pay Offs | Calculation | Take out profit @25% Gain & allow losses to run |
|---|---|---|
| +20% & 0% | 1Lx(1.2^30)x(1^30) | 2,37,37,631 |
| +25% & -20% | 1Lx(1.25^30)x(.8^30) | 1,00,000 |
| +25% & -40% | 1Lx(1.25^30)x(.6^30) | 17.85 |
| +25% & -60% | 1Lx(1.25^30)x(.4^30) | 0.00 |
| +25% & -80% | 1Lx(1.25^30)x(.2^30) | 0.00 |
If we keep cutting profits and allow LOSSES to run, will loose most of what we have.
With exactly opposite strategy, where you go against your own instinct. Cut your losses early and let the profits run, let us see what happens (Following example is with Cut all your losses at 15% ):
| Pay Offs | Calculation | Cut losses @ 15% & let profits run |
|---|---|---|
| +20% & 0% | 1Lx(1.2^30)x(1^30) | 2,37,37,631 |
| +40% & –15% | 1Lx(1.4^30)x(.85^30) | 1,84,67,531 |
| +60% & –15% | 1Lx(1.6^30)x(.85^30) | 101,43,01,928 |
| +80% & –15% | 1Lx(1.8^30)x(.85^30) | 3473,30,50,240 |
| +100% & –15% | 1Lx(2^30)x(.85^30) | 81934,65,72,581 |
For Technical analysts, STOP-LOSS is key, this model tries to explain the importance of it with Numbers.
| Subscribe To Our Free Newsletter |
