Use of stop losses is a trading commandment.  Without them, you risk losing your entire account.  This article is about how to select and place stop losses in order to protect your trading capital.  Some traders get stopped out all the time, while others take on too much risk.  Where should you place your stop losses?

The purpose of stop losses is to protect your trading capital in case a trade goes wrong.  A stop loss, as the name implies, limits your loss to a predetermined amount.

Why do this?  If the market moves strongly against you when you are using margin (leveraged), you could lose all your trading capital.  Generally as a rule of thumb, you should not risk more than 1.5 - 2.0% of your capital on each trade (that includes trades in other correlated markets, don’t risk 1.5% in 3 correlated markets, because you are in effect risking 4.5% at one time).

You can place a stop loss at the time you place a trade, and move your stop loss to follow the market if the market trends your way.  Once the stop loss is hit, an “at market” order is executed.  This will close your position at the next available price.  This may be quite some distance from the price that you want if the market is particularly volatile, so a stop loss doesn’t always limit your loss to the amount you want.

Where should you place your stop loss?  This is the big question.  You can place your stop losses a long way from your entry point and stay in the market even if there is a substantial move, potentially magnifying losses, or place your stop losses close to the entry point and risk being constantly stopped out by market noise.

In the latter case, using stop losses that are too tight will increase your risk of loss.  This is because you will have a lot of small losses, each of which erodes your capital, while some of the stop losses prevent you from entering into positions that are later profitable.

Larry Williams, a successful trader who is famous for turning $10,000 into $1.1 million, uses fairly wide stop losses.  For example, he traded the S&P 500 with a stop loss of $2,500.  This is large, but prevents being stopped out by market noise.

Ideally, stop losses should be placed based on market volatility.  In flat market conditions, stop losses can be small.  In volatile, noisy markets, they need to be wider.  The trader can use a market volatility measure such as average true range to determine the appropriate point to place stop losses by using a multiplier (for example, twice average true range).

A more sophisticated approach is to apply a noise filter to price data.  A good noise filter will remove high frequency data (random price movements) while highlighting the underlying trend.  This means that stop losses can be activated by changes in trend rather than being preset based on a set figure, or on volatility.

Irrespective of the approach you use, remember to always use a stop loss to preserve your capital.  This means selecting an approach that lets you benefit from the times you get the market direction right, ensuring that the random ups and downs of the market don’t trigger it, whilst getting you out of the trade when you have made a bad trade.

(No Ratings Yet)

 Loading ...

Tags: stop loss, Trading Rules

This entry was posted on Tuesday, April 1st, 2008 at 1:26 pm and is filed under Trading Rules. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.