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Stop-loss efficiency: how to make stops work for you

08:00, 17 March 2022

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Assuming you’re a tough cookie who knows how to trade, or at least think you know how to do it, you probably use stop-losses as an effective way to reduce trading risks and limit your losses in case of unfavourable price movement. However, are you sure you know how to do it right? Do you know which level to choose? What is your acceptable risk per trade? Do you know how and why to consider the volatility of the market when choosing a stop level?Let’s see what you can do to make stops work for you.

Why is it important?

Investors and traders like to enter trades that may help them to double their money, at least theoretically. Trading CFDs provides market players with far better opportunities. Using margin you definitely get more options to trade.

Stop-losses are widely applied for two major reasons – to prevent losing money or to lock in gains.

Stop losses can be useful tools to reap profits when positions turn out favourable, and they may save you from losing too much when the trend changes its direction against you. Effectively set, stop-losses may become an investor’s best friends, helping to limit trading risks. Improperly used, they will turn into a complete nightmare.

Risk per trade and volatility

One of the most popular and easy to understand methods of stop-lossplacement is to set a stop according to the amount of loss acceptable for trader in one trade. However, this approach ‘forgets’ about the volatility of the traded market. In order to use stops effectively, a trader should at least learn how to combine the two approaches – the risk-per-trade rule (the 2% rule) and the volatility-based method.

Traders should always be careful about where they set a stop order, as it could be undesirable if it’s activated by a short-term fluctuation in the stock's price. They should also remember that not all markets are suitable for trading due to high volatility and a trader’s limited amount of capital. Further we will discuss both methods separately and will tell you how to make your stops more effective, combining the two approaches.

A stop-loss based on a percentage of your account

A risk-per-trade stop-loss is the most common type of stop. For example, “2% of the account”, the sum a trader is ready to risk on a trade. This amount may differ from trader to trader, with aggressive traders risking up to 10% of their account, while risk-averse traders may prefer the less than 1% risk per trade ratio. Some traders stick to the rule to never risk more than 2% of their trading money on any position. This is the amount, often recommended for traders.

It’s highly important to understand that the 2% stop rule doesn't mean your position size can be only 2% of your account size. Actually, you can put all your capital on one single trade, or even more using leverage.

Implementing the 2% risk rule denotes that you take risk management and risk analysisactions in order not to lose more than 2% on one trade. If you have $20,000 on your account it means that if you place a stop in the opposite direction of the opened position, so that in case it’s hit, your loss won’t exceed 2% of your account or $400 in our example case – 2% of $20,000.

Please note, even if you feel totally safe using the 2% stop rule, remember that 5 consequent trades that ended up with the stop execution will “swallow” 10% of your capital. And in case you choose 10% risk per trade, ask yourself if you’re ok with losing 50% of your capital in case of 5 consecutive exits by stop.

Volatility: a cornerstone of stop-loss placement

Setting your stop, you should always consider the market environment first. Simply put, never ever forget about volatility, which represents the typical amplitude a market can move over a certain time frame. Learning how much an instrument usually moves in price may help you set a stop-loss correctly, choose an appropriate level and avoid getting out of trade too early.

Mistake #1 for traders and investors is placing stops too tight. A tight-fitting belt will leave you out of breath. The same with stop-losses.

Super-tight stops won’t provide you enough “breathing” space for price fluctuations.

The price may always “walk around” a bit before heading in a particular direction. The volatility-based method may help you with that.

For example, you decide to go long on CHF/JPY currency pair at 111.40 with a stop at 111.35. Even if your forecast is right and the price will go up from the current level, there is always a chance of the price falling down a little bit, before bouncing higher up to, let’s say 113.00. But how to find out what does this ‘a little’ really mean?

For CHF/JPY the average price move over the 15-minute range is 0.1.And there is a very high chance that the stop you’ve chosen will be executed within the next 15 minutes. The problem is, you won’t be able to benefit from the favourable price movement because you will be stopped by your own improperly set stop-loss that is set too tightly. Regarding volatility in this case, you should put a stop-loss, for example, at 111.20. (111.40 – 2 x 0.1, with a corresponding 2x for the average volatility of 0.1).

The moral? Never forget about volatility and don’t afraid to allow some space for your trade to succeed.

Successful combination of two approaches

Very often traders opening a position firstly decide on its size, and only then calculate the stop level based on the acceptable risk per trade. However, this approach has no any connection to market’s behaviour. So, the key fact to remember is to define the right consequence for your actions.

Since you’re trading the market, it makes sense to place stops depending on how this market moves, i.e. regarding technical analyses and volatility approach. Therefore, you’d better decide where to put your stop-loss first and then calculate the maximum acceptable size of your position, depending on your acceptable risk-per-trade. Besides, always remember that some instruments won’t suit you due to their high volatility and limited amount of your capital.

Let’s see. You want to buy a stock at $10. You have $20,000 on your account. You’re expecting that the price will go up during three days. Following the chart of the market you’ve chosen, have found out that in average the price of your instrument changes for $0.1 per day. Considering the volatility approach, you should put the stop at, let’s say, fifty percent bigger than its daily volatility, 1.5x0.1 = $0.15. Having set your stop at $9.85, you can calculate the amount of shares you can take in order not to lose more than 2% of your capital.

Let’s see! 2% of $20,000 is $400, which is your risk per trade. The price difference is $0.15 ($10 – $9.85 = $0.15, the difference between the entry price and the stop loss you’ve set). Dividing your risk per trade by the price difference you will find the proper size of your position. $400/$0.15 = 2666 shares. That’s how many shares you can take, without risking more than 2% of your account.

ATR method for volatility stop-loss calculation

There are numerous technical analysis instruments to manage stop losses including moving average indicators, trend lines, key market numbers in the market, market profile charts or volatility measures.

There are several ways to find out the average volatility and ATR method is one of the most popular. ATR, or the Average True Range, is a common indicator, used by most charting platforms.A standard ATR can help you measure a normal range for a particular market movement.It is pretty easy to use. All it requires is that you input the period or amount of bars, or time it looks back to calculate the average range. However, remember that you can’t compare the ATRs of several different instruments together.

The ATR method for stop-loss calculation lies in placing stop at X% from the current ATR value. The point of this method is to give your trade enough space for price fluctuations before it goes your way. The value of X can be different.

For example, you can take a look at an instrument’s daily chart and input 21 into the settings. In this case, the ATR indicator will calculate the average range over the last 21 days. You can also choose an hourly, weekly, or even a minute time frame and choose any period you’re interested in. Though, a period of 14 days is considered the most common. Let’s see:

As the Average True Range shows, the average fluctuation of the instrument’s behaviour, in order to set a proper stop-loss, it’s necessary to multiply the ATR by a certain multiplier at your choice – 0.5, 1, 2, 3, etc., – depending on your trading style. Intraday traders often prefer to multiply the daily ATR by 0.1 or 0.5, or find the ATR on a smaller scale (30 minutes, 1 hour, etc.) to achieve greater sensitivity to daily changes. The multiplier 2 is commonly used by short-term traders, while intermediate-term and long-term traders often use a multiplier 3 or higher. However, the choice of a multiplier is a matter of individual preference, depending on the trader’s risk tolerance.

Suppose you trade Gold and want to set a stop-loss to eliminate great losses. The Gold chart above shows you that the average volatility rate per day for trading the market is a bit more than 12. For an intraday order placement, you choose to multiply 12 by 0.5. That means that the specified stop will be executed if the price moves against you $6 from the enter price.

The ATR approach can be a major tool in limiting losses and also keeping hold of profits in trends. It can give you an edge by protecting your positions and limiting your losses. But the greatest benefit of using technical analysis for stop placement is the peace of mind it gives you.

Warning. Biases.

A stop-loss order, as well asa stop-limit order,is not acure-all solution to secure your portfolio. Nevertheless, it can be a reliable tool to safeguard your investments in some particular circumstances. In spite of the significant benefits, it’s far from perfect. Too many fresh traders and investors are prone to considering it as a shield from serious financial losses. However, stop-losses won’t protect you from slippage.

The “enemy” we should fight with in order to make rational decisions is in our emotions. No wonder that most traders hate losing. However, a well-known axiom of trading is “cut your losses quick and let your profits run”.

Loss aversion – the inability to survive a loss and the fear to lose gain – means that traders and investors often do the opposite. They literally “let their losses run and cut their profits short”. So, keep this in mind, when setting a stop according to the acceptable risk for the trade and taking into account the volatility.

Summary

Let’s revise the several simple rules we covered regarding the effective use of stop-losses:

  • Always define when to get out before opening a position.
  • Do not define your exit level only by the sum you’re ready to lose.
  • Find the stop levels that prove your trade wrong first (using volatility and tech analysis) and then calculate position size according to risk per trade.
  • Only move your stop in the direction of your profit target. Trailing stops are good, widening stops are bad.

Remember that some highly-volatile instruments may not suit you due to the size of your capital and the acceptable 2% risk per trade, because even at the minimal possible position size, provided by the broker, the stops can be tighter than volatility and don’t leave “breathing” space. There are two ways to work with such instruments – to increase your capital or to agree on much higher risks.

Setting stop-losses is both a science and an art. Find your own strategy and make it work.

To learn how stop losses can work for your strategy watch our video:
 

 

Capital Com is an execution-only service provider. The material provided on this website is for information purposes only and should not be understood as an investment advice. Any opinion that may be provided on this page does not constitute a recommendation by Capital Com or its agents. We do not make any representations or warranty on the accuracy or completeness of the information that is provided on this page. If you rely on the information on this page then you do so entirely on your own risk.

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