Pimp My Trade

How to Set a Stop Loss

Posted on February 15, 2009 by Adam

Who are better at trading: men or women?

Sorry, guys, but the girls have the edge here. In general, at least. I am a living exception to the rule, given that nobody beats me in trading!

In all seriousness, studies have shown that women make far better traders than men. Women tend to be more cautious, willing to cut their losses, and more reasonable in taking profits, while men are aggressive, stubborn, and greedy.

Well what else is new? As good as I may be at trading, I am no exception to the “men are aggressive, stubborn, and greedy” rule.

No matter whether you’re male or female, we can all benefit from intelligent risk management. That means knowing your risk before you enter any trade, and exit when that risk has been exceeded. It also means knowing where to take profits.

When I was new to trading, I struggled with knowing when to stop out of trades and when to take profits. Often, I was premature (another inherent flaw of the male persuasion) or too late in exiting trades, which ended up costing me money. I know that plenty of other people struggle with this aspect of trading.

This article will cover one aspect of risk management: the stop loss. If you find that you struggle with knowing when to close a trade (I certainly do sometimes) this article will help you in one way or another. Whether it’s preserving hard earned capitol from a trade gone sour, or protecting gains on a great one, using stop loss orders effectively can earn you more money.

Why Use a Stop Loss Order?

Stop loss orders will save you money in the long run. As a trader, the worst thing you can do is become so committed to a trade that you can’t leave it. At some point, you have to be able to admit the trade is wrong, exit the trade, and move on.

I promise you that it’s not worth fighting psychological battles with yourself. Allowing yourself to just let go and walk away will keep you from clinging to losing positions with a death grip. Using a stop loss order will help you fight the psychobabble that convinces you to stay in the trade.

When you enter a trade, you must objectively asses your risk. Before you commit a penny it is essential to define the point at which your trade is wrong. If the trade reaches that level, you get out. Plain and simple. Cutting your losses will keep you in the game. You have to understand that.

Some of you might be thinking, “I don’t like stop-losses. They mess with my mojo.”

I have to agree with you there, but I still use them. I agree with you because sometimes, when I place a stop order with my broker, it will get triggered. Then the stock turns right around and it turns out I got a terrible price. I call a stop-loss order that I place with my broker a physical, mechanical, or hard stop.

If you don’t like stop orders, don’t use a hard stop. Do what I do, which is write down my stop price and keep it in the back of my mind. If that level gets violated during the day, I will make a decision about whether or not to close down the trade. Most of the time I will watch prices for 15 minutes and decide to get out. If I don’t close my position immediately, I wait until the end of the day. If, by 4:00, prices are still beyond my stop price, I always exit the trade.

I tend to only use mechanical stops when I am away from my trading.

Where to Set your Stop-Loss

This is where your risk management comes into play. You should know your stop price before you enter the trade. In fact, it is the first thing I think about when sizing up a trade.

When I look at a chart of a potential trade, I immediately know where I would exit. The difference between my entry point and my stop-loss level is my risk. When I trade stocks over $20 (most of my trades), I will take on a maximum of about $1 of risk. That means I can exit the trade without thinking twice if the stock moves 5% against me. There are exceptions to that rule, but much higher and the risk to reward ratio makes the trade less favorable.

When you choose a stop price, choose a significant level of support or resistance that the stock has reacted predictably to in the past. Then add some wiggle room - how much depends on your pain tolerance, but I usually use $0.50-$1.00, never more, sometimes less.

For example, if I wanted to get long XYZ after it forms a strong base of support at $50, I would set my stop at $49.50. I would try to buy as close to $50 as possible to minimize my risk and then let it run. If I buy at $51 with a target price of 55, that’s an 8 to 3 risk to reward scenario. Not bad, but not great either.

Here’s an example with pictures for all you visual people. FFIV is trading in a nice symmetrical triangle pattern, and is approaching the top resistance line of the pattern. This looks like a good, low-risk entry point for a short. The stock is trading at 23.66 and is right at resistance. I’ll set my stop at the resistance line with just enough wiggle room to keep me happy. Let’s say $24.50 - giving me 84 cents of risk in this trade. In percentage points, that’s just over 1% - not bad.

FFIV is forming what could be a symmetrical triangle. We're pretty close to resistance, so set your stop just above for a tight risk profile.

I’m happy with the risk level on this trade - more often than not, I will take it, simply because of the risk profile here. When you factor in the price pattern, my price target is 20 - a risk to reward of more than 4 to 1. Not bad! You could even set your stop at 24 for an even better profile, but you then run the risk of getting stopped out on a whipsaw.

Let’s see what happens next…

Day 2 of the FFIV trade

It looks like the stock moved against us today, but only by 20 cents. I’m not worried at all. Our entry point may have been a bit premature, but we still haven’t reached our stop. In my eyes, this trade is still working. Once we break 24, I might start to sweat, but this is perfectly normal.

Let’s see what happens tomorrow:

Day 3 of the FFIV trade. Starting to move in our favor!

Today we had a decent move in our favor. This trade is working out nicely. I’m going to keep riding it.

Let’s fast forward a few days to where FFIV is trading as of Friday’s close (2/13/09):

FFIV has reached support in this triangle pattern

Would you look at that! FFIV has traded all the way down to support in the pattern we are watching. I’ve booked a bit more than a 6% profit so far, so I might take some profits here, given that a bounce of support is not unlikely, but I want to leave a portion of the position on here to see if it can reach my original price target of 20.

Moving a Stop-Loss

When I have booked a good gain in a trade, I often move my stop to reduce risk. In the case above, I might move my stop to break even, at 23.66. Some people like to use a trailing stop, which keeps following the stock price by a set amount. Both methods work.

Keep in mind that I only adjust stops on winning trades. I never move my stop on losing trades - why use a stop if you just keep moving it away to avoid getting stopped out? Never move a stop on a losing trade!

Conclusion

Stop-losses are the most important part of risk management. You must master risk management to becoming a succesful trader, and that means drawing a line in the sand. Exactly how you choose to draw that line is up to you, but if you can’t do it, trading might not be right for you.

If you have trouble exiting losing trades, try using a stop loss - and actually using it. Your account may thank you.

Happy Trading,

Adam