Stop loss is a key risk management tool. It closes an unfavourable position when a specified price is reached. However, to make stop loss orders work for you as efficiently as possible, you have to rely on common sense rather than gut instinct. Here are three sensible ways to cap losses in trading.
According to the method, a trader has to pick a perfectly comfortable percentage of capital he or she is ready to lose on a single trade. The more risk tolerant a trader is, the more loss they are ready to withstand.
When you choose an appropriate risk per trade, keep in mind that you can lose several trades in a row. If you choose to risk 10% per trade and lose 5 consecutive trades, will you be able to tolerate losing 50% of your capital? This is half of your funds! That is why the most recommendable and common risk-per trade level is 2%. If you lose 5 consecutive trades, then your capital will only shrink by 10%.
Now, how can the 2% rule be applied in placing stop losses?
A share of your capital you’re ready to jeopardise – 2% – is referred to as ‘capital at risk’. By dividing your capital at risk by the size of your position you arrive at the stop loss level – the price value by which a trade can go against (since entry) you before it is stopped out.
Need an example?
Let’s say you have $4,000 in your account. The 2% rule sets out that with this trading capital you can risk $4,000 x 0.02 = $80 on one trade. Suppose you want to buy 100 XYZ shares, trading at $50 (ask price). The stop loss level will be: $80/100 = $0.80. This means the share price has to reach $49.20, or drop $0.80 below the entry price ($50) for the stop loss order to be triggered.
The 2% rule is the most common method used to determine stops. But applied individually, it cannot guarantee favourable outcomes, because it doesn’t take into account market volatility.
Let’s look at the example above. The stop is placed at $0.80, but XYZ share usually moves $4 a day. With such volatility, your $0.80 stop loss level can be activated too early, after a regular daily price movement. The stop is placed too close to entry.
Volatility approach: average true range method (ATR)
Volatility and risk are paired together, with unstable markets being the most risky.
Knowing how a trading instrument moves can help you place stop loss levels correctly. The idea is to give it enough space for fluctuations, or else the stop loss order can be activated too early.
Let’s say you’re a swing trader who speculates on CPL stock. On average, the asset moves 100 points daily. If you place the stop loss level distance at 20 points, then you’re very likely to exit the trade prematurely after an irregular intraday fluctuation.
One of the simplest and most common ways to estimate volatility of an asset is the average true range (ATR) indicator. In the Capital.com app and web platform, ATR is found under the ‘Indicator -> Volatility’ tabs.
ATR gauges the average volatility of a trading instrument based on a certain time frame (week, day, hour or minute) for an indicated period. Suppose you want to find out the market’s average volatility over the last 14 days. You have to look at a daily timeframe and input 14 into the ATR period field.
Actually, you can use any set any period for day, week, hour or minute time frames (14 is just the most common one). For example, use a weekly time frame and period 7 to calculate average weekly volatility for the last 7 weeks. Or combine a 1-hour time frame with period 10 to gauge volatility for the last 10 hours.
A logic-driven way to determine the volatility-based stop loss level is to multiply the current ATR by 0.5, 1, 2, 3 or more – you choose.
As a rule, intermediate and long-term investors multiply daily ATR by 3. Multiplier 2 is appropriate for short-term traders. Intraday and swing traders, in turn, choose 0.1 or 0.5 as a multiplier for daily ATR, but they can also combine a smaller time frame ATR (1 or 30 minutes) with a multiplier 2 for bigger sensitivity to daily changes. Generally, 2 is the most common multiplier as well as period 14. However, the choice is very individual.
Suppose you trade Netflix shares and want to place a stop loss order to limit losses. In the NFLX chart below, the entry point for a long position on the stock is $300. The average volatility for 14 hours on a 1-hour time frame is about 5. For short-time order placement, you multiply 5 by 2. This means the stop loss order will be triggered if the price moves $10 from the open price against you.
Support and resistance approach
Here’s another sensible way to determine stops – support and resistance.
Sometimes, prices can’t penetrate certain levels. Support is the lower limit line, and resistance is the upper one. These are important price areas, accumulating heavy volumes: support gathers buyers, while sellers converge at the resistance level.
Sometimes, market tests support or resistance areas, and they can cause the trend to bounce back. However, when the price pushes through, more traders can kick in and push the trend further upwards or downwards.
There are many ways to define support and resistance levels. One of them is to use trendlines. When the market is trending downwards, traders have to track a series of rising peaks, connect them with a trendline and get a resistance level. On the other hand, when the market is trending upwards, watch and connect falling peaks to get the support level. For example:
Understanding how support or resistance work is vital to placing a stop loss smartly. Frequently, trends reverse at these levels, and if you set a stop loss directly at the support/resistance level, you may be stopped out prematurely. Instead, place it slightly above resistance or slightly below support.
In the chart above, you can see that the Bitcoin price has bounced upwards from the 8,960.00 support level. To cap potential losses on a long position, a trader has to place stop loss a bit under – at 8,940.00. Thus, he or she will be stopped out only if the support level is penetrated.
What should your reasoning be like
Firstly, let’s have a glimpse of common mistakes.
The first and most common one is placing stop losses too tightly. The asset’s volatility has to be taken into account and the price should have enough space for fluctuation. Stop losses placed too close to entry points are triggered early, and you miss the chances of profiting.
The second mistake is dedicing position sizing before determining a stop loss based on risk-per-trade approach. This has nothing to do with market behaviour and technical analysis whatsoever.
Let’s illustrate this idea with an example. Imagine there’s a potentially profitable stock – ABC – that you want to buy. It’s daily ATR(14) is 2.5, so based on price volatility, it is better to place a stop loss at a $5 distance from the entry ($2.5 x 2).
Now that you’ve determined a stop loss level, it’s time to calculate an appropriate position size. This is done based of the 2% rule that says:
capital at risk / difference between entry and stop loss level = position size
So, you have already calculated that the stop loss should be placed at a $5 distance from entry. Your capital is $2,500, so based of the 2% rule you can risk $50 per trade (capital at risk). Now you know everything to gauge the size of your position:
$50 / $5 = 10
10 shares – this is the maximum position size you can set. If your broker doesn’t provide this size, then increase your capital or choose another instrument to trade.