Have you ever gotten into a position, then suddenly have buyer’s remorse?
How about entering a trade and suddenly feel like the market is hunting your stops to take you out of your position?
Those are two of the worst feelings—after all, nobody enjoys losing money. If you don’t have the right strategy in place, you’ll be sure to go through those emotions.
However, at times, even the most experienced traders have a hard time dealing with their stops being hunted and ultimately end up trading without any at all… leading to even more losses than if they kept using stop losses in the first place.
But lucky for you, all this is totally avoidable just by using some basic risk management strategies for your trades.
First off… what is a stop loss?
A stop loss is an order that protects your trading capital when the price moves against you.
The SPY’s are trading at $327.00 with a stop loss set to 1.5% below your entry price of $324.88.
This means that the SPYs are going to have to sell off below $324.88 in order to execute your stop order restricting your loss to $2.12 per share.
This is what it would look like with an overlay of the order on the SPY chart.
And if this is used correctly, a stop loss will :
- Prevent you from blowing up your account
- Allows you to trade and fight another day
- Limits your losses and minimizes psychological impact
The truth about stop losses
Let’s talk about some of the biggest myths about stop losses.
Unfortunately, many of these myths are created by traders who don’t necessarily understand the inner-workings of the financial markets and spread to others as the “truth”.
This is dangerous and has led to many people having their accounts blown up from bad trades because they don’t use stops. They are led into thinking that they won’t help them.
Some common myths behind stop losses are :
- Algos and brokers hunt my hard stop
- Hard stops are just random levels anyways
- Hard stops only lock in losses
- Only set hard stops below support and above resistance
But those things are not true!
Let me explain exactly why…
Myth #1: The algos or brokers hunt my stops
Most brokers and HFT firms are regulated by the financial exchanges in order to trade on behalf of their clients account.
These firms specialize in connecting the buyers with the sellers and charge a small fee to conduct business.
Other services brokers and HFT firms offer to their clients are packages called Smart Order Routing algorithms.
In short, these algorithms focus on seeking the best price and liquidity for their traders orders to be filled at with minimal impact on the financial market centers.
So think about this…
If word gets out that ABC broker hunts their clients stop loss, it’s only a matter of time that a trader will pull their funds and join a new broker.
If you were a broker, why would you want to risk a much larger business chasing these sub-penny profit opportunities?
It doesn’t make much sense to me!
So logically, it’s safe to assume that most brokers do not hunt stops as the risk far outweighs the reward.
Now you might follow up with, “what about if the spreads get wider when I am about to trade?”
And there is a reason for this. And it’s nothing shady.
Let me explain…
A bid/ask spread is a measure of uncertainty in an underlying stock, also known as volatility.
The greater the volatility or uncertainty in the stocks future price will result in wider bid/ask spread for the trader.
Similar things also occur before major news releases as well.
For example, if you look at a level 2 (depth of markets) prior to the news release, you will also notice there is a lack of volume since major HFT firms are pulling their trades from the markets due to increased uncertainty and risk levels.
And in return, the spreads widen, which increases volatility, and causes more HFT firms to remove their orders deeper in the markets causing decreased volumes.
So the cycle continues until it reaches a breaking point, and market participants place their orders again.
In short, this is not your broker widening the spread because they feel like it, but instead, due to market conditions they are adjusting for to protect their business.
The bottom line is this…
- Brokers don’t hunt your stops because it’s bad for business in the long run.
- They do in fact widen their markets but it is usually due to major news releases or future events they are protecting themselves against
Myth #2: Hard stops are just random levels anyways
Now this is a huge mistake many traders make…
It might not seem obvious but not every stock is created equal.
Here’s an example:
Right now FB is showing a hardstop value of approximately $3.50.
So here are two levels that I like to look at when trading FB long at this level.
The Stop 1 is set to 1 ATR value, of $3.55 below the entry price.
I typically don’t recommend trading at athis tight of an ATR level since the hardstop can be taken out in a short period of time.
Pro Tip: Use an interval of the ATR to calculate an offset and come up with a more accurate hardstop level to exit your trade at.
In the image above, reference stop 2.
See what I mean? As the stocks volatility moves around, so does the amount of the hardstop. This is why you would not want a fixed hardstop value and you can take advantage of the market movements.
Myth #3: Hard stops only lock in losses
You might think that having a trailing stop is dumb.
Because the markets always seem to trigger your trailing stop loss and then reverses back and continues in the original direction.
And you know that if you continued to hold the initial position that you would have never exited and instead caught that huge move.
But what if the stock doesn’t reverse and continue in the original direction? What price would you eventually exit at?
The answer is most likely, you will never exit and end up holding a major loss as you watch your trading account blow up.
There have been many times where I watched a stock continue without me after my hard stop was triggered.
And it has actually happened so many times to be I have lost count.
But I can tell you I am better with the hardstop than without it.
Here’s the thing…
All you need is ONE time the market doesn’t reverse, and you lose it all.
Let’s take a look at an example trade in Apple where a trader could go short an intraday “double top” pattern.
Now in this example, if you sold AAPL around 13:00 on the double top that was formed, you would have been sure to stop out.
The question now is, how much of a loss do you take?
Without hardstop: Unlimited
That was the calculations for a hardstop that would have gotten you out near $314…
But say that you didn’t listen to that resistance level and kept the trade on…
Here’s what happened next…
You would have taken a massive loss relative to your acceptable loss limit determined by the stop exit price.
Do you see what I mean?
I know it makes you upset when your stop gets hits unnecessarily.
But you’d be glad you have it when stuff hits the fan!
Only set hard stops below support and above resistance
This is a very bad idea.
Because this is where the markets move to.
Remember, the markets move between areas of support and areas of resistance.
Therefore, if the stock is range-bound, it is most likely to pass your hardstop value that is placed right near one of the key levels.
And that is due to human psychology.
Since humans are trading the markets and make up every price you see, you can experience periods of bleeding over.
Say you were looking to go long FB and you wanted to use a prior support as your entry price and stop loss price.
Well, looking at the chart above, this could be a costly mistake.
Why does this happen?
Well, this happens due to human nature and emotions. The closer you get to critical support or resistance levels, the more dramatic the price moves in the stock.
How to set up stop losses like a professional
Here is a quick 2-step process that just works…
- Determine market structure, ie) trend vs chop
- Place stop loss at a calculated position away from
You can use this on any market or timeframe
Here is how:
Identify Market Conditions
Some key things to refer to are support and resistance lines, trenlines, and other major market impacting zones.
The key to identifying market structure on your chart is to locate a price at which the stock would have difficulty reaching your stop loss at.
Set stop loss at offset away from market structure
Remember… you don’t want your stop loss at the market structure (such as, support or resistance) because you may ( or may not ) be stop hunted.
Insead, you want to make sure your stop loss has a buffer added to it away from the market considiton.
- Find the current ATR value
- Add the ATR value above market structure for short
- Subtract ATR value below market structure for long
So here’s what you’ve learned:
- A stop loss protects your capital when the markets move against you
- You want to set stop losses away from major market structures so you don’t get stopped out easily
- The tighter the stop loss, you can increase position size keeping risk constant
- The best trading opportunities occur near the market structure (double top/bottom) because you can have tighter stop losses.
- A trailing stop loss allows you to ride massive trends and protect your open profits