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Many investors struggle with the task of determining where to set their stop loss levels. Investors don’t want to set their stop loss levels too far away and lose too much money if the stock moves in the wrong direction. On the other hand, investors don’t want to set their stop loss levels too close and lose money by being taken out of their trades too early.
So where should you set your stop losses?
Let’s take a look at the following three methods you can use to determine where to set your stop losses:
- The percentage method
- The support method
- The moving average method
The Percentage Method for Setting Stop Losses
The percentage method for setting stop losses is one of the most popular methods investors use in their portfolios.
[VIDEO] The Percentage Method Stop Loss
One reason for this method’s popularity is its simplicity. All you have to do when using this method is determine the percentage of the stock price you are willing to give up before you exit your trade.
For instance, if you decide you are comfortable with a stock losing 10 percent of its value before you get out, and you own a stock that is trading at $50 per share, you would set your stop loss at $45—$5 below the current market price of the stock ($50 x 10% = $5).
The Support Method for Setting Stop Losses
The support method for setting stop losses is slightly more difficult to implement than the percentage method, but it also allows you to tailor your stop loss level to the stock you are trading.
[VIDEO] The Support Method Stop Loss
To use this method, you need to be able to identify the stock’s most recent level of support. [Learn more about Support and Resistance.] Once you have done that, all you have to do is place your stop loss just below that level.
For instance, if you own a stock that is currently trading at $50 per share and you identify $44 as the most recent support level, you should set your stop loss just below $44.
You may be wondering why you wouldn’t just set your stop loss level at $44. The reason is you want to give the stock a little bit of wiggle room before deciding to exit your trade. Support and resistance levels are rarely accurate to the penny so it is important to give the stock some space to come down and bounce back up off of its support level before pulling the trigger.
The Moving Average Method for Setting Stop Losses
The moving average method for setting stop losses is more simple than the support method, but it also allows you to tailor your stop loss to each stock.
[VIDEO] The Moving Average Method Stop Loss
To use this method, you need to apply a moving average to your stock chart. Typically, you will want to use a longer-term moving average as opposed to a shorter-term moving average to avoid setting your stop loss too close to the price of the stock and getting whipped out of your trade too early.
Once you have inserted the moving average, all you have to do is set your stop loss just below the level of the moving average.
For instance, if you own a stock that is currently trading at $50 and the moving average is at $46, you should set your stop loss just below $46.
Just as in the example above using the support method, you should set your stop loss just below the moving average to give the stock a little room to breathe.
Image Courtesy of Randy Son of Robert.
As an investing enthusiast with a deep understanding of various strategies, I can provide valuable insights into the methods mentioned in the article. My expertise is grounded in both theoretical knowledge and practical experience in financial markets.
Percentage Method for Setting Stop Losses: The percentage method is indeed a popular and straightforward approach for determining stop loss levels. Investors, especially those looking for a simple yet effective strategy, often rely on this method. By calculating a predetermined percentage of the stock price, investors can establish a clear exit point. The example in the article illustrates how setting a stop loss at 10% below the current market price provides a predefined risk tolerance.
Support Method for Setting Stop Losses: The support method introduces a more nuanced approach to setting stop losses. It requires investors to identify the stock's recent level of support. Support levels indicate where the stock has historically bounced back from declines. By placing the stop loss just below this support level, investors aim to allow for some price fluctuation while still protecting their positions. This method requires a keen understanding of technical analysis, particularly support and resistance concepts.
Moving Average Method for Setting Stop Losses: The moving average method offers a balance between simplicity and customization. By applying a moving average to the stock chart, investors create a dynamic reference point. The choice of a longer-term moving average helps avoid premature exits triggered by short-term fluctuations. Setting the stop loss just below the moving average allows for a flexible yet systematic approach to risk management. This method is effective in capturing the stock's broader trend while providing room for normal price movements.
Understanding the nuances of each method is crucial for investors to make informed decisions based on their risk tolerance, market conditions, and the specific characteristics of the stocks they are trading.
In conclusion, successful investing involves a combination of knowledge, strategy, and adaptability. By employing these stop loss methods judiciously, investors can enhance their risk management practices and navigate the complexities of the stock market with confidence.
