Improve your trading performance by setting Stop Loss like a pro
Although stop loss orders may be a topic that most trading blogs will prefer to avoid writing about (as it relates to losses and not to glamorous wins), for me, placing a proper stop loss order is the difference maker between ending up with a profitable trade and between watching a profitable trade working as planned without you in it.
Most newbies and novice traders are setting their stop loss orders based on the Dollar Value of their acceptable risk. That is actually a common mistake that you should avoid and instead, as I will demonstrate with real trading example from last week, your stop loss order placement should be based purely on technical analysis.
These days, with illiquid markets and the spread of algo trading, false breakouts and stop loss hunting are becoming more and more frequent . That makes the topic of setting a proper stop loss even more critical and even more crucial to understand and master.
What is a stop loss?
As defined by Investopedia.com, a stop loss order is an order that is placed with a broker to sell (or buy in case of a short trade) a security once it reaches a certain price that reflects the max risk you are willing to take on a trade
A stop loss order is meant to take the emotions factor out your trading decisions. The stop loss should be defined before your enter the trade, when you aren’t emotionally involved with the trade, and (assuming that you are trade according to your plan) its purpose is to take you out of the trade if and when the price reaches a level that violates your initial setup.
The whole purpose of a stop loss order is to keep you away from define your acceptable risk and prevent you from making an emotional trading decision when you are carrying a loss.
Hard Stop Loss vs. Logical Stop loss
There are many ways to implement a stop loss:
- Setting a Sell/Buy orders that will cover your position once they are touched by the price (hard stop loss).
- Setting Sell/Buy orders that will scale you out of the position as the price advances against you (also defined as hard stop loss, only gradual)
- You can also use Logical Stop Loss orders that aren’t based certain price levels and instead they are based on certain markets conditions. You do this by using Indicators such as MAs or ATR for example.
- You can also define your risk by using certain options strategies (straddles, Iron Condors etc..)
With the increased frequency of False Breakouts and Stop Loss Hunting activities by market makers, there are some traders that prefer to work without an actual stop loss order. Instead of using a Sell/Buy orders they have a logical stop loss and alerts that are based on a longer term analysis and defined by specific markets conditions that support it (like volume, candle sizes, volatility etc.). Once those pre-defined markets conditions are no longer vaild, they manually get out of the trade — Obviously such an approach isn’t made for anyone and it is more suited to longer term traders (swing traders and position holders) and highly experienced traders that also know how to control their emotions and cut their losses when they need to.
Pro Guidelines to setting a stop loss
Here are few Dos and Don’ts guidelines for setting a stop loss like a pro:
The Don’ts
DO NOT set your stop loss based on a random amount of pips! — People often “feel like” what their stop loss should be (“I feel like I should use a 25 pips stop loss… that should be enough”).
DO NOT set your stop loss based on how much money you are willing to risk — Your position size should be determined by where the stop loss is, not the opposite.
DO NOT move your stop loss once you’ve placed it properly
DO NOT place your stop loss near obvious price levels (like round psychological levels for example)
