Cut-Off Point

A Cut-Off Point is the predetermined price at which an investor or trader chooses to purchase or sell a security. It is a subjective limit set by an investor based on their constraints and characteristics, such as the risk-taking ability and required rate of return.

Moreover, it is the point that determines the tolerance level of an investment, beyond which there cannot be any trade. Different investors have varying perspectives, objectives, and strategies; therefore, their cut-off decisions are usually driven by their personal choices. However, such decisions are critical for avoiding losses, maintaining account equity, and securing gains when stock prices fall.

Key Takeaways                                                               

• A cut-off point refers to the upper or lower limit set by an investor or trader for buying or selling the security in a specific timeframe. It is the strategic decision to stop losses, close profits, or safeguard the capital during security trading or investment.
• In finance, it is the minimum rate of return threshold desired by an individual or company to make a capital investment or proceed with a particular project.
• In trading, there are three different forms – daily, weekly, and overall cut-off points.

The cut-off point in finance signifies the minimum acceptable rate of return or price that justifies proceeding with a capital investment or security. This limit is based on perceived risk levels, rising with higher risk and decreasing with lower risk. It acts as a safeguard, ensuring that capital investments yield returns above the corporate cost of capital to avoid adverse business returns.

However, market conditions, interest rates, economic indicators, and regulatory changes are the other factors that contribute to these decisions. Furthermore, company-specific constraints like financial health, growth prospects, and industry trends are pivotal in establishing these thresholds for investment decisions or financial strategies.

For investors, it is the price level at which decisions to buy or abstain from purchasing a security are made. This concept offers a consistent guideline, aiding investors in evaluating whether a security is attractively priced based on expected returns and risk tolerance. It serves as a benchmark, facilitating informed and consistent financial decision-making in both investment and capital budgeting scenarios.

The cut-offs serve as a safety net for the traders, especially the intraday traders who would otherwise exhaust all their account equity if their trading strategies fail and they constantly incur losses instead of profits from securities trading. Let us understand the three different types they can set in trading to stop losses:

#1-Daily cut-off point

In trading, there is a predefined limit for the maximum allowable losses within a single day. This strategic approach is designed to prevent impulsive decision-making and additional losses during a single trading session. However, adhering to a daily cut-off demands discipline from intraday traders, prompting them to stop trading until the following day, providing an opportunity to reevaluate strategies with a clear and objective mindset.

For instance, if a trader sets a 5% daily cut-off, they commit to halting trading activities once their cumulative losses reach or surpass 5% of their account equity. Now, they will begin trading from the next trading day.

#2-Weekly cut-off point

It functions as a risk management strategy for traders. Suppose an individual undergoes consecutive daily losses when the daily cut-off point is 5%, potentially resulting in a substantial cumulative loss of 25%. In that case, the weekly cut-off point serves as a protective measure. 

For example, if a trader sets a weekly cut-off point at 10%, it means that if their total losses for the week equal or surpass 10%, they should halt trading for the remaining week. This approach aims to manage and mitigate the impact of a constant losing streak, establishing a practical limit to safeguard the overall account balance. However, the trader should strictly adhere to these predetermined weekly limits to make the strategy effective.

#3-Overall cut-off point

In trading, it is a pre-specified maximum risk tolerance limit. It represents the maximum acceptable loss within a defined trading period, like a year. It is a risk management measure that helps minimize the chances of substantial losses, ensuring that a few unfavorable trades don't exhaust the entire trading capital. The specific percentage chosen varies among traders based on individual characteristics, risk tolerance, and trading strategies. 

Let's understand the concept application in security investment and financial aspects.

Example #1

Let's assume that an intraday trader has set a daily cut-off point for the loss on trading as 7%. If he trades ten times and incurs a loss six times out of it, while the average loss incurred on the account equity reaches 6.75%, then if on the 11th trade he again makes a loss of 0.25%, he has to stop trading immediately as per the 7% loss tolerance limit set by him.

Example #2

Suppose ABC Corp. is a construction company and invests only in projects that yield a minimum of 25% returns. Suppose it receives a proposal from the government to construct a housing society for the below-poverty class on the government-allocated land. After a proper analysis of the project, the company found that it would make only 18% of returns, which is below their cut-off point. Hence, ABC Corp. rejected the proposal.