Correctly place your stop loss when trading
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Definition of stop loss
A stop loss is an essential tool that allows you to limit losses on all of your trades. It is also a level at which you feel that your scenario will not occur. A stop loss is mandatory for each position if you don’t want to see your trading account at zero. All it takes is one trade to make you lose all your capital, the trade or the price never returns to your entry price, or it does so too late.
Using a stop loss has a lot of advantages and few disadvantages. It's a good habit to get into. However, a lot of mistakes are made in placing stop losses, especially among novice traders. We are, therefore, going to look together at how to place a stop loss on a trade.
Advantages of a stop loss
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Enables you to limit your losses
: By using a stop loss, you know your risk in advance (before opening a position), that is the maximum amount that your trade can cause you to lose. This is the basis of money management (risk management).-
No charge
: Using a stop loss is free and does not generate any commission from your broker. A stop loss works a bit like insurance, if your trade loses, you recover a large part of your funds (or rather a large part of your capital is not put at risk on the trade). With a stop loss, this insurance is free of charge.-
Frees you to do something else
: By using a stop loss, you do not have to constantly monitor your trade and you no longer have to sit at your computer screen following the asset price changes. A stop loss enables you to have free time once you are in position. Be careful, this does not mean that you should not monitor your trade from time to time to possibly move your stop loss when there is a favourable price movement.-
It is impossible to lose all your capital
: On a trade, you should not risk more than 2% of your capital at most. It is even advisable not to exceed 1%. To lose, all your capital, you must therefore have a chain of 100 losing trades. Even with a bad trading strategy (or none at all), it is therefore impossible to lose everything. Testimonies from novice traders who have lost all their capital and who say that trading is a scam make me angry. Losing all your capital is not related to market risk, only to poor risk management.-
Enables you to insure your earnings
: People often forget that a stop loss is not only about limiting losses. A stop loss also makes it possible to guarantee a part of your earnings or to have zero risk on a trade (when moving your stop loss to your entry price). This is the case when you move your stop loss after a favourable price movement. Moving the stop loss can be manual or automatic, using the following stops. Moving stop loss means that you can let your earnings run while guaranteeing a minimum amount of capital gain.Disadvantages of a stop loss
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Increases the number of losing trades
: Using a stop loss can make your trades lose out even if your bullish/bearish scenario is good. Effectively, your stop loss can be triggered on a peak of volatility or simply be triggered on a price rebound/correction which is more pronounced than expected. You have to accept it, losing trades are part of trading. Later, we will look at how to avoid this phenomenon as much as possible. However, be aware that even with more losing trades than winning ones, it is quite possible to generate returns with your trading strategy.-
Possibility of slippage
: Once your stop loss is reached, it turns into a market order. It is therefore possible that in the event of high asset volatility at that time, you may be the victim of slippage. This means that your execution price may be different from the level of your stop loss. This happens especially during important economic announcements, when financial market volatility is at its highest. On the stock market, you may also be the victim of an opening gap. To overcome this defect, some brokers guarantee stop loss levels. So choose a broker who offers this option.Frequently made errors in placing a stop loss
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Stop loss too close
: A stop loss should not be too close to the entry price, unless you are scalping. If you practice swing trading, you need to let your trade breathe. Your price objective will not be reached in a straight line, the price will make correction movements. Similarly, at the time of opening a position, the price may go in the wrong direction. It is rare to be able to buy at the lowest and sell at the highest.-
Stop loss too distant
: On the other hand, a stop loss should not be placed too far from your entry price, to avoid it being reached. This is the same as not using a stop loss and you now know the consequences of that. You must accept losing in order to win in the financial markets.-
Stop loss determined by position size
: A stop loss must be determined by a market level and not by the size of your position. It is the level of your loss that determines the size of your position and not the other way around! This is an essential part of money management.-
Forgetting to take the spread into account
: Depending on the asset’s liquidity and volatility, the spread offered by your broker is bigger or smaller. Since your stop loss is placed at a high market level, you need to add the spread when you place your stop loss. Remember that your buy or sell is always made at the lowest price within the price range indicated by the broker.-
Stop loss on a key level
: Key levels can be a resistance, a support, a round number or a highest/lowest point. It is important to place your stop loss at these levels. You have to include a margin in your stop loss. Your stop loss should therefore be placed slightly above/below this key level (including the spread).-
Moving a stop loss
: A stop loss should never be moved when there is an unfavourable price movement. The stop loss level is determined when opening a position. Moving a stop loss should only occur in the event of a favourable price movement, so as to reduce your risk or to guarantee part of your earnings.How to place your stop loss correctly?
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Placement according to market level
: It is important to place your stop above/below a key level. This can be a resistance, a support, a highest/lowest point, a trend line, etc. The distance between your stop loss and your entry price therefore varies on each trade. The further away your stop loss is, the more important it is to reduce the size of your position.-
Respect the rules of money management
: One of the basic principles of money management (risk management) is the risk/return ratio. On each of your trades, your risk (your stop loss) must never be greater than your expectation of gain (your price objective). The risk/return ratio should normally not be less than 1 and tend towards 2. If you see that this condition is not being met, you should not open a position. Respecting this money management rule enables you to have a winning strategy in the long term, despite a ratio of winning trades to losing trades of less than 1. Effectively, with an average risk/return of 2 on all your trades, a winning trade covers two losing trades. By winning on 1/3 of your trades, you don't lose any money.-
Consider asset volatility
: The more volatile an asset is, the greater the risk that your stop loss will be triggered by a volatility movement. On a volatile asset, you must therefore place your stop loss further away. This element must be taken into account, especially if you are trading on a long-term basis, in long time units. For example, if a stock has a historical daily volatility of 3%, you should not place your stop loss at 1% below/above your entry price if you plan to hold your position for one day or more.-
Take the time unit into account
: The longer your trade’s time unit, the further away your stop loss should be. On 15 minutes, your stop loss will be in the order of a few tens of points, on a daily basis, your stop loss will be in the order of several hundred points. Your trade’s time unit will therefore be closely linked to the size of your positions.-
Moving a stop
: Moving your stop loss only occurs when there is a favourable price movement and should only be carried out under certain conditions. The price must be far enough away from your entry price before it can be moved to the neutral position (stop loss = entry price). You can also move your stop loss if a new highest/lowest point has formed but you must wait for a reversal in the direction of your trade before making the move. Finally, if your price objective is reached, you can tighten your stop loss to protect your earnings while still enabling you to benefit from a possible trend continuation.-
