Why is the risk reward placed opposite on the downtrend ?

More at: r/NepalStock by A_man_from_himalaya

  1. You are basically referring to a short position.

    Short position is when you borrow stocks from the broker and sell it to make profit. If you have a news that the price of certain stock will go down maybe because you have predicted their earnings to deteriorate or maybe you have some insider information and you want to capitalise on it. If the current market price of the stock is 200rs per unit. You will get into a short position whereby you will borrow let’s say 100 units of the stock from your broker. After borrowing you immediately sell the stock at the present market price of 200rs. Now you have 200rs*100units = 20000 on hand because you just sold. If the stock tanks this week to 180rs per unit. You will take the 20000 and buy 100units of the stock at 180per unit because you borrowed it from the broker and hence must give it back. You sold something for 20k, bought it for 18k and made 2k profit. Basically you bought low and sold high.

    Hence your target price is at lower because you want to be able to buy low at 180 to deliver the borrowed stock which you sold for 200.

    Your risk is that, if you were wrong and the stock price went up because your earnings predictions and insider information was not legit, then the stock could have increased to 250rs per unit. Since you borrowed and sold the stock thinking it will go and and later you would buy and pay back but since the stock increased to 250 you are at a loss because the stock your broker lent you was actually someom else’s. Hence you have to give the stocks back as per the agreement/deadline. If the stock price never comes down to 200 and the broker asks you to give back the stocks which you had sold. You are forced to buy the stock at higher price let’s say 250. You sold something at 200 and bought it at 250. Basically opposite of buy low sell high.

    Hence in short position, the risk is upside that is the price of stock going up, so the stop loss is kept at above the price you sold the stock after borrowing the stock. Your borrowed and sold at 200rs, you put a stop loss at 218rs so that the maximum loss you can have is 18rs per unit. And you put your target at 180s which is the price at which you will buy the stock and give the broker back the stocks you initially borrowed.

    You open position looks like this.

    Setp 1 : Borrow stock 100units and sell at 200. You have an immediate Inflow of 20000.

    Step 2 : Buy 100units at 180 ( any price lower than 200). You have an Outflow of 18000.

    Step 3 : Give the 100 units borrowed at step 1 back to the broker.

    Hence making 2000 profit.

    Had the stock price in step 2 increased to 300 and the broker asks you to return back 100 units. You would be forced to buy 100unit at 300rs. Your Outflow would be 30000. A loss of 10000. Hence tour target is below the step 1 price, and stop loss is above the step 1 price.

    For a short position it’s called stop loss buy order. For a long position its called stop loss sell order.

    (In case you are wondering how does the broker give you 100units? Not 100% of total float is traded. Mutual funds, long term investors, etc usually hold stocks for long term. Hence the broker will borrow some stocks from them and give it to you. And you have to repay back the borrowed stocks because it actually belongs to someone else. And this facility isn’t available in Nepal.)

    Hope this helps.

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