Always set a stop loss order when day or swing trading. While we form expectations and make trading decisions based on what we believe will happen using our tested method, the fact is at any moment price can do anything. Not having a stop loss in place leaves you susceptible to a very large loss. Stop losses control risk, but need to be placed at a price that still allows the market to move toward the target. Once set, a stop loss can also be managed as the trade progresses.
What Are Stop Loss Orders
The stop loss is an order placed at the same time a trade is opened, to control the maximum loss of that trade.
A stop loss is an offsetting order, which when triggered (the price touches the stop loss price) will close out the position at any price available. This can result in slippage, meaning the loss–even with a stop loss order–may be larger than anticipated. While this is a drawback, I have found that typically I would have taken an even larger loss had my stop loss not been there. Overall, slippage has never been an issue for me and I have been trading since 2005.
It is important to place a stop loss so you have a good idea how much a trade could lose. While no one wants to take a trade thinking they will lose, losses are a constant in trading, and losses must be kept in check in order to succeed.
Setting a stop loss also allows you to determine your position size. If you don’t set a stop loss it’s very hard to choose a position size that is in alignment with the account size.
I choose not to risk more than 1% of my capital on a single trade. Even following these guidelines it is possible to make a substantial amount of money (see: How Much Money Can I Make as a Day Trader). Risking up to 2% per trade is acceptable once you have a well established system that you know provides consistently favorable results.
Stop Losses and Position Size
Let’s say you have a $10,000 trading account. If you risk 1% of the account you can risk $100 on a trade. Without a stop loss “$100” means nothing–you need to define your stop loss and then calculate your position size in order to define how that $100 will be risked.
Let’s say you decided to buy 100 shares of stock at $50 and place a stop loss at $49 (risking $1 per share). If the stop loss is hit then you have lost $100. Therefore, the ideal position for your stop and risk management protocol is 100 shares. But in order to figure that out you had to set the stop loss (also see: Position Sizing Strategy for more examples from various markets).
This example greatly simplifies things though. A stop loss should not be placed at an arbitrary level. It should be at price level, that if hit, will show you were wrong about the trade (at least for now).
Where to a Set Stop Loss When Trading
I use one method for setting a stop loss, and it can be applied to almost every strategy I trade. Have a stop loss method you can use no matter what market you are trading, or not matter what time frame, it greatly simplifies things.
My preferred stop loss method is a fixed stop loss. It may vary slightly based on what market I am trading or what time frame, but overall, every single day and every single trade I know that my stop loss is going to be pretty close to this fixed amount. This is covered in several strategies in my Forex Strategies Guide eBook. This method allows me to put my stop loss close to my entry price, but still far enough away that it won’t get hit if my analysis is correct.
For example, when I swing trade major forex pairs I typically enter on a breakout of a small consolidation. My stop loss is placed 5 pips outside the opposite side of the consolidation from the entry. The chart below shows an example of this. The AUDUSD formed a choppy consolidation right along a descending trendline. This signaled that I wanted to go short when the price started to drop again. I took a short (middle blue line) and placed a stop loss 5 pips above the consolidation high (upper yellow line marked “stop”). In the forex market you have to account for the spread on your stop loss when you are in a short trade, so in this case, my stop loss would actually be placed 5 pips, plus the average spread, above the consolidation high…or about 6 pips above the consolidation high.
The same method is applied when day trading forex, except my stop loss will go 1 pip (plus the spread when applicable) outside the consolidation. This makes it easy to place stop loss orders quickly, and not have to second-guess where you should be putting it on every trade. How to Day Trade Stocks gives examples of this stop loss method when day trading stocks.
This stop loss method is designed for the strategies I trade. It may not work for all strategies; if you trade a different strategy you will need to calibrate your stop loss so that it’s effective for your method. Effective means it gets you out of trades that would have resulted in even bigger losses, but still allows you to profit on more than half of your trades.
Inevitably, sometimes you will get stopped out only to watch the price immediately move back in your direction, producing what could have been a profitable trade. Welcome to trading. This happens. If your profits are bigger than your loses and/or you have a higher win rate than losing rate, you will still come out ahead. Letting a loss grow is a much bigger issue than getting stopped out.
When I day trade ES futures I use a similar approach. Every day, every trade, my stop loss is the same. It is placed three ticks above/below the consolidation I am selling/buying in. Since I always try to buy within one tick of a consolidation low, or sell within one tick of a consolidation high, my stop loss always begins at four ticks (occasionally five depending on my entry and volatility) on every single trade. This allows for me to rapidly place orders. My initial target goes 8 ticks away from my entry point.
Where to Set a Stop Loss – Stop Loss Management
New traders should allow the market to hit their original stop loss or target–“set it and forget it.” Actively managing trades complicates the trading process and can induce a lot of emotion which new traders may not have the skill set to deal with. That said, some basic stop loss management–such as reducing risk once a trade is closing in on the profit target–is acceptable. Risk should never be expanded; move stop loss orders to reduce risk, but never to increase risk.
I utilize a few simple guidelines to get out of trades early (not let the price hit my stop loss or target):
- If day trading, I get out of a trade about 2 minutes before a major economic news announcement.
- If swing trading, I get out of a trade if the current price is close to my stop loss or target and a major economic news announcement is coming out soon.
- Stop loss is contracted to near breakeven once a trade is 50% of the way to the target.
- Stop loss is further contracted, guaranteeing a profit, once the price moves 75% of the way to the target.
- If the price moves very close to the target, but doesn’t fill the target (get you out), manually get out immediately.
That’s it. Keep it simple.
Where to Set a Stop Loss – Final Word
With day trading and swing trading you need to control risk. Use a stop loss! A stop loss is required in order to determine your position size. My method is to place a stop loss at the point closest to my entry point that won’t get triggered if my analysis and expectation is correct. When I am wrong, I am wrong small. Letting the price hit your stop loss or target is recommended when you are starting out; don’t intervene in your trades while they underway. As you improve, and you have the discipline to let the price hit your stop loss or target, then consider managing your stop loss while in a trade to potentially improve performance. Actively managing won’t always result in greater profits though. If letting the price hit your stop loss and target works for you, don’t mess with it.
Trading is one way for people with desire, discipline and the willingness to put in some time can earn an income from anywhere in the world. Check out The Forex Strategies Guide for Day and Swing Traders 2.0. It leads you step by step through a process for becoming a successful traders, as well as providing strategies and trading plans you can use to build your capital in a risk controlled manner. This eBook is a complete course on forex trading, from basics to advanced tactics.
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