3 Simple Steps to Proper Stop Loss Placement
“If you can’t take a small loss, sooner or later you will take the mother of all losses.”
— Ed Sekoyta
No trader is correct 100% of the time. Setting proper stop losses allows traders to control their risk so that, even when they do have losing trades, they are able to survive with enough capital left to keep trading.
One of the problems many beginning traders face is figuring out where and how to set their stop losses.
Some find it so confusing that they just decide to place a random stop loss based on their feelings. Others decide not to set a stop loss at all, opening their accounts to the risk of huge losses or total liquidation if the market moves too quickly for them to react.
In this article, we will go over three simple steps for setting and using stop losses to avoid massive losses without getting stop hunted.
Step #1: Find Protected Areas
One question some beginning traders ask is what set percentage or dollar amount they should set all of their stop losses for every trade. While having a set number is easy to remember and execute, this kind of stop loss is not based on what is actually happening in the market.
Instead, learn to read the charts and place your stop losses behind areas where technical analysis suggests price could be contested.
These contested areas would serve as protection for your stop loss. They increase the likelihood that other traders will step in and at least put up a fight before you are stopped out of your trade.
If you find yourself getting stopped out often, increase the number of technical barriers that must be broken before your stop is taken.
For example, if you are planning to place your stop behind a support/resistance area, you may also want to place it beyond a moving average or ichimoku cloud to give your stop more ‘protection’ before it gets hit.
Step #2: Adjust to Market Conditions
To avoid getting stopped out prematurely, adjust your stop loss positioning and strategy based on market conditions.
Depending on the momentum of the trend, you may want a tighter or looser stop loss. Going long in a strong uptrend may allow you to get away with a tighter stop. However, if you are going for a potential reversal long entry in a strong downtrend, you may need to set a looser stop loss.
Stops can also be adjusted based on the market’s volatility. One way to do this is by using the Average True Range (ATR) indicator, which increases or decreases based on how much price has been moving. To give your trade some room to breathe, the value of the ATR can be added to your planned stop loss position. Optionally, a set multiple of ATR (e.g. 2 times ATR) can be used to set your stop as well.
Tip #3: Adjust Your Position Size
Based on the stop positioning techniques given above, you may find that your stop loss is quite far away. This is great for helping you avoid getting stop hunted, but not great for your portfolio if you have to exit at a large loss.
To counteract this, change the size of your trade so that even if your wide stop loss is hit, you do not lose more money than your account can comfortably handle.
If you wanted to risk only 2% of a $10,000 account in each trade, then you would calculate your position size so that you would lose $200 if the stop loss was hit.
Stop losses are a great tool to avoid huge losses and irreparable damage to your account. However, they are a double edged sword.
If used and placed incorrectly, they can kick you out of an otherwise winning trade. However, when used properly, stop losses protect your account from unexpected large losses and give you the ability to continue trading even if you make a few mistakes.
When combined with proper risk management, stop losses will allow you to trade with much greater peace of mind and keep you in the game long enough to become profitable.
With a mastery of stop losses and money management, you’ll be able to safely take advantage of all the different trading opportunities available every day on PrimeXBT, which lets you trade forex, cryptocurrencies, stock indices, and commodities, all in one easy Bitcoin-based account.
To get started, sign up at TheBirbNest.com/PrimeXBT.