The Art of Stop Losses

by | Feb 18, 2020 | blog, Editorial | 0 comments

Stops can be used to cut losses or secure profits. Some traders will actually put a stop order in… while others will use a “mental stop”. A stop order basically gets you out of the stock when it hits a specific price. 

A “mental stop” is just a level you wish to get out at, but you still have to physically hit the buttons to get out. 

If you place your stops “too tight” you can be out of a trade quickly. It can be especially frustrating if you get stopped out, and then watch the stock we were in—reverse in the direction of your trade. 

This can drive some traders crazy, forcing them to jump back in, churn their account, or even revenge trade.   

But it shouldn’t… 

Getting stopped out is a normal part of trading… sure it’s hard to shrug off.

Not every trade will be a winner. 

Now I bet you’re thinking, there’s nothing to do but just take the loss and move on?

Not so fast… 

You see, there are some strategies that you can apply to improve how and where you place your stops. It’s a rules-based approach that I believe can save you a lot of money if you just hear me out. 

Not only that, I’m going to show you what the most common mistakes people make with setting stops… and how to button them up.

 

What is a stop loss order

 

First…what is a stop loss order and what does it even do?

A stop loss is an order that helps to protect your trading capital when the price moves against you.

An example:

You buy SPY at $337/share and you have a stop loss order at $320.

This means that if the price of SPY drops to $320, you will exit the trade and limit your loss to $17/share.

And if you use a stop loss correctly:

  • A stop loss prevents you from blowing out your trading account
  • Allows a trader to “live and fight”
  • Limit your losses to paper cut size 

 

Common issues of using stop orders

 

But I know what you’re thinking… the markets “hunt” my stop-loss order.  

Let me change your mind and debunk the major issues using stop loss orders.

 

Issue #1 : My stop-losses are “hunted”

 

Stop losses are not “hunted” by the markets or the brokers.

Why?

Because it’s not worth the regulatory nightmares that it will cause them!

Many times the markets will sell off to levels where other traders have their stop levels set.

Such as this example in the SPYs:

 

 

As you can see… if you placed a stop order below the prior pivot, you would have been out of your long trade just to watch the market move without you.

Why does this happen?

It happens for two main reasons:  

  • The market doesn’t have buyers entering the market since they already bought in at the prior pivot price to dampen the selling pressure
  • If there are new buyers coming into the markets, they are trying to get the best possible price, and will target prices under prior pivot levels.  This is a symptom of herd mentality.

So there you have it…

Now you know why your stops seem to be triggered by “stop hunters” but in actuality, they are actually triggered by other market traders.

 

 

Issue #2 : Stop loss should be based on account size

 

So an account based exit rule is just a way to exit if you lose too much money.

For example, 

The stop rule: exit position if losing 3% of initial capital.

This is one of the worst ways to place stop orders, yet it is taught in almost every trading 101 handbook.

Why is that?

Because it is simple and easy to communicate with new traders.

So what’s the solution?

Next…

 

How to set a stop loss like a pro?

 

Since not all stocks are created equal, a simple way to solve this is to use an indicator to offset the price that is unique per stock.

The solution?

It’s best to use the value of the ATR to offset the stop level.

Let’s take a look at how that would have worked on the SPY trade from earlier.

 

 

As you can tell, you were never stopped out of this trade and were able to capture the oringial move higher.

Why did this work?

For a 2 Reasons:

  1. The stop doesn’t follow the herd 
  2. It’s adapted for each stock’s volatility

So what does this mean?

This means you shouldn’t use a fixed stop loss under a pivot that the herd will be using as well.

Here is an easy to remember, 2 step technique that works…

  1. Identify market structure
  2. Offset stop losses using a stock-based indicator

The best part?

This can be used on any stock and on any timeframe.

Pro Tip:  Avoid using other common herd hard stop levels, such as areas of support and resistance without applying a stock-specific offset like the atr to the price level.  

Let’s take a look at exactly that.

 

1. Identify the market structure

 

Market structure refers to things like Support, Resistance, Trendlines, Moving Averages, etc.

This structure acts as a barrier and makes it difficult for the price to go through.

For example, let’s think of support as a barrier that keeps price from going lower.

The key about this is identifying the market structure and setting up your hardstop levels prior to placing a trade.

 

 

2. Set up the stop loss away from market structure.

 

Remember…

You don’t want to set your stop loss at the market structure directly since you will be “stop hunted” very easily.

Instead, you will need to give your stop loss some sort of “buffer” away from the market structure to give you the wiggle room needed.

Here’s how:

  • Find the current ATR value
  • Add the ATR value above market structure for short
  • Subtract the ATR value below market structure for long

Here’s what I mean:

 

 

You can see two things that happened quickly:

  • The stop loss without offset had the trade exited
  • The stop loss that was offset was still left on the books.

 

Conclusion

 

Remember, stop losses and risk management consist of 3 main components:

  • Distance to stop loss
  • Risk per trade
  • Position sizing

Pro Tip:  If you’re a serious trader, you’ll only risk a fraction of your capital per trade to avoid being blown out with a major loss.

A final word of caution on stop loss placement…

There is no perfect stop loss placement, since trading is all about playing the percentages.

Here is a recap of what was covered:

  • A stop loss protects your capital when the markets move against you
  • You want to avoid using static stop losses based on dollar value
  • You want to avoid using a market structure stop loss without an offset
  • It’s always best to add a offset to all offset levels, typically using ATR values
  • If you have tight hard stops, you can increase your position size to maintain constant risk
  • Best trading opportunities are typically found near market structures because you can have a tighter stop loss

 

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