This is a vast topic and numerous manual have been written on stop loss orders – and it is a skill that can only be mastered through practice. The stop loss levels differs from individual to individual because of different risk tolerance and particularly for the more volatile markets such as forex trading which can move rapidly, some people are simply afraid of utilising stops.
The classic investing proposition is that after you have made a strong profit but now signals turn mixed:
- If it is a high risk proposition sell enough to cover your buy cost.
- If it is lower risk long held position sell down the over-weight proportion of your holding compared to your other holdings.
Spread betting is even more flexible in that it allows you to enter positions a bit at a time (without being penalised by higher fees for making separate trades) and this allows you to close part of your bet and keep the rest running.
In practice I believe deciding on a stop loss level depends on the instrument you are trading, your trading timeframe and style of trading. If your trading positions are based on momentum tight stops are a no-go. For longer timed-trades (swing trading) on less volatile markets a wider stop might be in order so that you allow the position to survive the normal market noise.
Choosing your stop loss level will depend on several factors:
- Trade time horizon (the longer the timeframe, the bigger the stop loss needs to be…)
- Market’s volatility (a more volatile market needs wider stops with lower stakes…)
- General market conditions (more volatile markets need wider stops or you risk having the trade stopped out prematurely)
- Quality of your trading signal and how confident you feel about the trade.
How to Choose a Stop Loss Level
Looking at charts is one of the better ways to determine where your stop loss order should go. There are plenty of features on a chart that you can use as stop reference points. For instance, you can choose to put your stop just below a recent low when doing a ‘buy’ bet or just above a recent high when selling. Or you might use a moving average line (red) or a trend line (purple) as your benchmark
Another popular strategy to find suitable stop levels is to look for support and resistance points and place stop losses just beyond these points. Some also make use of other (less convincing) methods like setting fixed-price stop losses or simply set stops a fixed percentage away from the present price or just use a stop based on a set number of points away that is computed by estimating how much you are willing to risk. Another method to choosing stop loss levels is to simply work out how much you are willing to risk on the trade. So, you might operate a fixed percentage rule, such as a 3% rule. So, if you entered a buy trade at 100p, you’d automatically put a stop-loss at 97p.
However, care needs to be taken so as not to place a stop at unfavourable levels on a chart. For instance it wouldn’t be wise to place a stop at a recent low point or on a support or resistance level as such levels are more likely to be tested. Spotting support and resistance levels should be fairly simple with a decent software package and reliable prices. The more times a set price has bounced off a particular level, and the longer the time period in consideration, the more important the level. Round figures and landmark numbers can also represent important psychological barriers such as 10,000 for the Dow. However, placing a stop loss level on a round number is not recommended, just as you would do well to avoid setting stops at exact support or resistance levels.
Likewise, setting your stop orders too tight to the current market price is not a good idea as you’ll likely end being stopped out easily on minor day-to-day market fluctuations and each stop-out will make you lose a small bit of money on the bid-ask spread as well as tempting you to re-establish your trade on every stop-out. So always make sure to set your stops at a reasonable distance. Stop loss orders should be sufficiently away from the present price so as not to be triggered by normal day-to-day price volatility and sufficiently high so as not to expose you to too much loss to you. This is the tricky part.
“One other thing to bear in mind is that you’ll rarely if ever get out at the very top of a rise. Don’t worry about giving up a certain percentage in profits. If you devise a signal that indicates it’s time to take profits and you can consistently go with it, you’re still taking profits, and the few percent you miss out on is just an accepted loss.”
Also, you should make sure that the distance to your stop loss allows for a decent reward-to-risk ratio. Let’s suppose you are expecting a rise in the market of 200 points, which is your profit target. You would not then place your stop loss 200 points below the price at which you buy. This is because a one-for-one is not a good reward-to-risk ratio. Ideally, you should be targeting profits at least three times as large as your potential losses.
One thing to keep in mind, though: the only case that you should ever move a stop-loss level is to protect a position that is already in profit. If you get your trade wrong, then just admit you got the market direction wrong and try to see what happened. Then, simply move on to the next trade. It is also good practice to make sure that a loss is affordable so as to avoid ‘panic decisions’ in the heat of the moment. Thus, only execute trades where the stop losses will allow you to keep your mind at rest.
How much you’ve made or lost this year has nothing to do with using stops. Protecting what’s left with minimum risk and discipline is what matters. One system is to use looser stops when things are rising and tighten them if the gains look like shrinking.
Incidentally, if thinking about closing a position, I don’t actively do so most times – but merely tighten the trailing stop as close as allowed. If the price does go against me it closes itself. If it surprises by shifting in my favour it closes itself when dropping back to a stop that has automatically edged itself slightly higher.
“But am I shooting myself in the foot not having a clearer way of knowing when to sell, or at least strong exit signals, opposed to just using my own judgement of when a stock has run out of steam?”
Relying too much on your judgment is dangerous (although a relevant factor). You beat yourself up when things go wrong and can’t make rational, emotional free judgement calls when things are moving against you.
Start by asking what would I feel comfortable with initially losing or how much of your profits are you prepared to give back to the market. Imagine you have £100,000. Now assume the market pulls back and you see your £100k start to fall. £95k, £90k, £85k, £80k……
What is an acceptable loss to you as a percentage of your capital? You have to be honest with yourself. Because spread betting firms allow you take trades worth many times the amount of funds in your account, you can easily get wiped out if things go against you. Suppose you have deposited £10,000 into your spread betting and utilise the full leverage available to open a £100,000 position in Marks & Spencer shares. If the shares were to move by just 5% against your position, you have lost half your funds on a single trade! This is why its critical that you adopt strict rules about how much of your account you should risk on any one trade.
If your acceptable loss is just £5k then you need a 5% stop. If you can accept £20k then you have the benefit of a 20% stop. A 5% stop will mean a lot more trades, more trade costs, small losses with only small gains and a lot of time watching the markets. The 20% stop means far fewer stop outs, less trades, less trading costs, more chance of collecting a dividend, larger gains but larger losses on losing trades and larger draw downs on market retracements with much less time watching the markets. Now, if you find your available time to watch the markets is limited but you only want to lose a maximum of £5k or only give back £5k drawdown from profits you have an alternative. You can reduce the amount of trading capital and put the remainder into a fixed income account. So let’s assume you like the look of the 20% stop for longer term investing but you are only prepared to lose £5k. You have to reduce your exposure to investments down to a capital of £25k instead of £100k. The remaining £75k needs putting somewhere safer than the stock market. I make this point because I believe a lot of people come into the markets with a large wedge of cash and put too much at risk. The consequence is that they can’t find a suitable stop because they are too greedy, so eventually they get emotionally wiped out and exit the markets altogether with a loss.
Note: A common mistake amongst new spreadbetters is to place stops at levels which dictate the maximum loss they are willing to sustain. As traders we are always told to cut losses early and run profits. Experienced traders however utilise stop loss orders not only to limit losses, but also to close out positions when the market prices swing to price levels that render the purpose for getting into the original trade wrong, like for instance when a market breaches a key support level.
Let’s consider an example. A typical deal might be to BUY £1 per point on the FTSE 100 at 5700, placing a stop at say 5400 to limit the loss to £300. This means if the FTSE were to fall to 5400, the stop loss order would be automatically triggered and the trade closed. This does cap the loss to £300, but in reality the wider picture has to be examined when working out a stop loss level aside from purely one’s maximum loss allowance.
Let’s say that in this example the fact that the trader’s logic behind the buy trade was the fact that the FTSE has repeatedly in the past found support at 5600 and bounced back from this support area. This could imply that from a technical viewpoint, if the FTSE were to trade below the 5600 support level, it could be in for a short term bearish move lower. Thus , instead of placing the stop level at 5400, setting the stop level so that it sits just below 5600 at 5580 would likely be a better option as this would help to minimise losses and lock the trade out when the logic for entering the trade has been deemed wrong.
“I blame the high frequency traders. The moves are too small to be able to make cash from, it’s difficult to run a winning trade, if we take profit at 10% but entered the position using a 10% risk then we’re just coin flipping or gambling.”
Coin flipping trades are not the answer. If you are trading with a trend then you have a better than 50/50 chance of winning. If you trade against a trend you have less than 50/50 chance of a win. If you bottom fish bear trends you have less than 50/50 chance of a win.
Perhaps try moving your stop to breakeven ASAP, its stressful and frustrating getting lots of breakeven stops but gives you experience, a good feel for price action of the instrument you are trading and most importantly it protects your capital.
Most of the successful traders I know operate strict rules about how much of their account they risk on any one trade. So, you might decide never to risk more than 5% of your funds per trade. For a £10,000 account, therefore, you would limit your maximum loss to £500 on any one trade.
Another issue is regarding what you are trading. Blue chips are far less volatile then small caps or micro caps so you can use a afford a larger stop or a larger percentage of your investment capital if you concentrate on blue chips. The next step is money management. You know your acceptable % loss and the optimum size of your trading capital so you can now apply those figures to work out your maximum number of trades and the trade size. That’s why it’s no good asking others what stop they use. You have to assess your available time, risk adversity and what size stock you are trading at the time – different market caps require different stops for constant risk management. It’s all a very personal thing where no size fits all.
“Stops should differ based on risk appetite and the stock in question, but either way emotion should never come into the equation. When it comes to cutting loss making shares, I find it easier to be ruthless.”