Cutting losses and letting the winners roll is one of the oldest principles of trading and investing. The next question is: what is a stop loss strategy and how could it help determine where to set stop losses?
In this guide, we attempt to answer these questions by explaining some of the most widely used stop loss techniques.
What is a stop loss?
A stop-loss order is a market order placed with a broker to buy or sell a security when it reaches a certain price. This is done to limit losses in the event that the price of the security moves against the position taken by the trader.
A stop loss on a long position would be a sell order at a price below the entry price. A stop-loss order on a short position would be set above the entry price.
This method revolves around the protection of your own capital. When it comes to stop loss strategy options, the risk-per-trade approach to reducing escalating losses is simple and is considered an effective way to manage risk when trading.
By determining the maximum amount of risk you are willing to take on each trade, you can set a stop loss that will limit your losses if the trade goes against you.
The maximum risk you are willing to accept on a trade should be a dollar amount or the currency in which your trading account is based. The dollar amount is determined as a percentage of the total trading capital value of your account.
There are several ways to calculate your risk per trade, but one of the most popular is the 2% rule. This principle says that you should never risk more than 2% of your account on a single trade. So if you have a $10,000 account, you should never risk more than $200 on a trade.
The risk-reward stop-loss order strategy compares the size of your stop loss with the size of your expected take profit order.
Certain risk-reward ratios can be used as guidelines. For example, a risk-reward ratio of 1:3 means that for every point of risk, the potential reward is 3 points. This ratio can be used when the market is moving strongly in one direction.
Another example is a 1:2 risk-reward ratio, which can be used when the market is limited or choppy. In this case, the trader is looking for a small price movement in order to make a profit. Note, however, that all trading involves risk and some losses are unavoidable.
Of course, these are examples and each trader will need to find the stop loss types with risk-reward ratios that work best for them.
There is no right or wrong answer, but a risk-reward ratio can allow traders to minimize the downside without limiting the upside.
Note, however, that all trading involves risk. Always do your own due diligence before trading. And never invest money you can’t afford to lose.
Volatility stop loss is a strategy that uses market volatility to determine where to place your stop loss.
Volatility varies – there may be more or less movement in the market over time. Using market volatility, you can change your stop size to match current market conditions, placing your stop loss in a more strategic location.
For example, if over the past 10 days the S&P 500 stock index has moved an average of 20 points per day, it may not make sense to have a stop loss of more than 20 points for an intraday trade.
The classic volatility approach to stop losses is the “average true range method”, using the ATR (Average True Range) indicator.
The ATR is a measure of market volatility. Using the ATR, you can place your stop loss at a point just beyond the furthest price likely to be reached under current volatility conditions.
Although incorporating volatility into how you choose a stop loss can add value to your trading strategy, it is worth bearing in mind that the ATR is a lagging indicator, which means that it cannot predict future levels of volatility, only tell you what it was like in the past.
Note that past performance is not indicative of future returns. And never trade money you can’t afford to lose.
Support and resistance approach
Using support and resistance (S/R) areas is a classic method for placing stop losses. This strategy may be the clearest in terms of placing stop losses.
The logic is that if the price breaks above one of these price levels, it invalidates the reason for being in the trade and is a signal to exit the trade. Support and resistance are the common way to put a stop loss in swing trading.
The support and resistance approach to where to place a stop loss is a technical analysis strategy that is used to identify key price levels where price is likely to bounce or retrace.
A support level could prevent the price from falling and a resistance level could prevent the price from rising. Therefore, placing a stop loss just below a support level or just above a resistance level could increase the chances of a losing trade reversing in your favor before the stop loss is reached. .
These S/R levels are usually identified using previous highs and lows, as well as using technical indicators such as moving averages (MAs) or Fibonacci retracements.
The benefit of this stop loss method is that it can help identify key price levels where price is likely to find support or resistance. This can help place stop-loss orders which are more likely to be effective in limiting losses.
The downside of this approach is that it is based on technical analysis and is therefore subject to interpretation. Technical analysis is based on historical price action, which does not guarantee future returns.
A trailing stop loss
A trailing stop loss strategy is most applicable in trend following. Trend followers attempt to enter a price trend right after it has started and exit right after it has ended.
Trend followers don’t try to predict how long a trend will last. They do not set a “take profit” level in advance. Instead, trend followers will normally use a stop-loss order to exit a trade, even if it is still profitable.
A trailing stop loss will be set a number of points or a percentage behind the entry price. If the market starts to move in your favor, the stop loss will follow the market price by that same number of points.
When the market pulls back, the trailing stop stays in place. If the market falls, the full size of the stop-loss order is triggered.
Some traders use a moving average such as the 50 DMA to stop loss entry so that when the moving average rises in an uptrend, the stop loss increases accordingly.
Stop Loss Limits
A stop loss is a tool for traders to reduce but not eliminate trading risk. Stop losses are not infallible and have certain limits. Even using the techniques above, it can be difficult to determine the correct level at which to set a stop loss.
If a tight stop loss strategy is used and the stop loss is set too close to the current price, it can be triggered by a small fluctuation and result in a loss. On the other hand, if the stop loss is too far from the current price, the potential loss may be too great.
Even if the stop loss is set at the right level, there is no guarantee that it will be triggered – markets can be very volatile and prices can move very quickly. Unless it is a guaranteed stop loss, which usually incurs additional fees.
Market makers at large institutions such as banks and hedge funds can see where stop losses are on their books. This gives them a huge advantage over retail traders and some will engage in a stop loss chasing strategy. This usually involves executing large sell orders to trigger stop losses, which causes an additional wave of sell stop orders, creating a short-term profit.
Finally, if a stop loss is triggered, it may be difficult to re-enter the market at a good price, as prices may continue to move in the same direction.
In conclusion, there is no single best stop loss strategy, but there are a variety of techniques that are best used depending on your trading strategy and risk management profile.