Risk management is by far the most important component in any trading system. While stock selection is important, risk management is the key to longevity in the market.
All else being equal, a trader with poor stock selection and sound risk management will outperform and survive longer than the trader with great stock selection and poor risk management.
Stop losses are a key part of this process. They’re like insurance bills, which you hate paying until coverage is needed. But just setting stop losses isn’t sufficient. Traders also need a sound strategy to keep risk inline and minimize needlessly getting stopped out.
What’s a Stop Loss?
A stop loss is a standing order to exit a position if its price crosses a certain level. Stop losses can automatically update (trailing stops). Or they can only execute if other conditions are true (stop limit).
However you use them, stop losses are one of the most common risk-management techniques in the market.
Minimizing Risk
Risk management requires setting stops according to a system. Without rules governing risk areas, it’s not much of a system at all.
Once the proper risk is determined along with the entry price, a trader must calculate whether the distance to the stop price makes sense. Also, can they afford the potential loss based on their capital?
This risk should be pre-planned before the trade occurs and should not change once the trade is live. Traders also need nonnegotiable rules to keep risk per trade below a predetermined amount. (This is expressed as a percentage of assets in the portfolio.)
This keeps risk consistent and small. It also provides visibility about what would cause a major drawdown in an account.
Stop Losses and Position Sizes
The most widely accepted industry standard today is risking no more than 1 percent of a portfolio on any given trade. If a trader finds a desired position has too much risk based on their portfolio, they should avoid the trade or reduce its size.
Here’s an example of determining the position size for a trade using the 1 percent rule :
Position size = (Total account value * risk percentage ) / (entry signal - risk area)
Let’s illustrate with real numbers:
- Total account value (TAV) = $100,000
- Risk percentage = 1 percent
- Entry signal = $56
- Risk area = $49
Position size = ($100,000 * 0.01 ) / ($56 - $49 )
Position size = 1,000 / 7
Position size = 142 shares
That's the largest size that should be taken on this trade.
Traders must heed these points. While it can be tempting to go outside of one’s system or take a trade that looks especially juicy, it is important to think in a long-term manner.
Buying too many shares for a given risk area is a recipe for disaster. It can also inflict major damage to an account if only a few trades go wrong. Furthermore, oversized positions can wreak emotional havoc and cripple decision-making. Regardless of whether a system is quantitative or discretionary, rules must govern the amount of capital at risk.
Tools For Setting Stop Losses
Traders can determine stop-loss prices based on many techniques. For example, there are pivot levels on price charts or volatility indicators like Average True Range (ATR). Moving averages are also common. Like much of trading, “there are many ways to skin a cat.”
Still, remember that the market always tries to fool the masses and shake out weak hands. Often a stock will drop below an obvious stop and scare you away before resuming its trend higher. Traders can plan for this in a few different ways:
- Give more of a buffer by widening the stop and reducing the position size.
- Wait for a close below a certain level. That can offer more confirmation than just a few ticks.
- Use a confluence area to trade against so that there is less chance of price breaching the stop level. A confluence area is a place on the chart where multiple indicators line up. For example, a pullback-style trader might wait for a stock to retest an earlier breakout zoneanda moving average. By having two areas of support and placing the risk below them, odds are tilted in their favor.
Also remember time frame impacts risk tolerance. A day trader using a one-hour chart for a signal should have much tighter risk than a swing trader with a weekly view. The key is to find an area within your time frame where price is unlikely to go. And then only cut the position if that level is reached.
In conclusion, most traders don’t spend enough mental energy placing stop losses. By going outside the normal day-to-day swings and considering the position size, big strides can be made toward long-term success.
FAQs
Stop loss is a fundamental risk management technique used by traders and investors to protect their capital. It involves setting a predetermined price level at which an investment will be automatically sold if the market moves against the desired direction.
What is the 7% stop loss rule? ›
However, if the stock falls 7% or more below the entry, it triggers the 7% sell rule. It is time to exit the position before it does further damage. That way, investors can still be in the game for future opportunities by preserving capital. The deeper a stock falls, the harder it is to get back to break-even.
What is the 1% rule in trading? ›
The 1% risk rule means not risking more than 1% of account capital on a single trade. It doesn't mean only putting 1% of your capital into a trade. Put as much capital as you wish, but if the trade is losing more than 1% of your total capital, close the position.
Is the GTT order good? ›
Benefits of GTT Order
Placing a GTT order has a lot of advantages, but here is a list of a few. Investors do not need to track market movements continuously once they place a GTT order. To place an order, investors need to set their desired target and stop loss prices.
What is the best stop loss strategy? ›
Summary and conclusion - Stop-loss strategies work
The best trailing stop-loss percentage to use is either 15% or 20% If you use a pure momentum strategy a stop loss strategy can help you to completely avoid market crashes, and even earn you a small profit while the market loses 50%
What is the 3-5-7 rule in trading? ›
The strategy is very simple: count how many days, hours, or bars a run-up or a sell-off has transpired. Then on the third, fifth, or seventh bar, look for a bounce in the opposite direction. Too easy? Perhaps, but it's uncanny how often it happens.
What is the golden rule for stop-loss? ›
The golden rule of Stop Losses is that they should never be moved away from the market once the trade is opened. If a trader feels that their stop loss is incorrectly placed, they are recognising that the foundations of their trade are incorrect and therefore they should close out.
What is the number one rule in trading? ›
Applying the 1% Rule in a Single Trade
This should be money that you can afford to lose without it affecting your lifestyle. Calculate 1% of your risk capital. This is the maximum amount you're allowed to risk on any single trade.
What is the 90 90 90 rule traders? ›
There's a saying in the industry that's fairly common, the '90-90-90 rule'. It goes along the lines, 90% of traders lose 90% of their money in the first 90 days. If you're reading this then you're probably in one of those 90's... Make no mistake, the entire industry is set up that way to achieve exactly that, 90-90-90.
What is the golden rule of traders? ›
Use protection: Losing trades need to be kept under control, while profits should also be protected. Use stop losses wherever you can, allowing for adequate breathing space. 8. Learn from your mistakes: Keeping record of both wins and losses can help avoid trip ups int he future.
A one-cancels-the-other (OCO) order is a pair of conditional orders stipulating that if one order executes, then the other order is automatically canceled. An OCO order often combines a stop order with a limit order on an automated trading platform.
What is the OCO trigger type? ›
OCO (One Cancels Other) – 2 Entry Prices are required with the order Price and Quantity (Can be considered as 2 legs). When any one of the Entry Price is triggered, other trigger is automatically cancelled. This type of GTT can be used as Stop Loss and Take Profit legs.
What is the amo order? ›
An After Market Order (AMO) allows investors with the flexibility to place buy or sell orders for stocks and other financial instruments outside of regular market hours. Regular market hours are typically limited to the time when the exchange is officially open for trading.
Which indicator is best for stop loss? ›
TRIX Indicator: The TRIX Indicator is a momentum-based indicator that can be used to generate stop-loss levels by identifying potential trend reversals and market volatility.
What stop loss do day traders use? ›
Most of the traders use the percentage rule to set the value of the stop-loss order. Usually, the one who wants to avoid a high risk of losses set the stop-loss order to 10% of the buy price.
Why stop losses are a bad idea? ›
The main disadvantage is that a short-term fluctuation in a stock's price could activate the stop price. The key is picking a stop-loss percentage that allows a stock to fluctuate day-to-day, while also preventing as much downside risk as possible.
What is the 7% rule in the stock market? ›
Always sell a stock it if falls 7%-8% below what you paid for it. This basic principle helps you always cap your potential downside. If you're following rules for how to buy stocks and a stock you own drops 7% to 8% from what you paid for it, something is wrong.
What is the 6% stop-loss rule? ›
The 6% stop-loss rule is another risk management strategy used in trading. It involves setting your stop-loss order at a level where, if the trade moves against you, you would only lose a maximum of 6% of your total trading capital on that particular trade.
What is the 8 loss rule? ›
The 8% sell rule is a strategy used by some investors to minimize losses and help preserve their capital. The rule is typically applied when a stock drops 8% under your purchase price—regardless of the situation. Keep in mind that this isn't a hard-and-fast rule.
What is the formula for stop-loss? ›
Calculate Stop Loss Using the Percentage Method
Additionally, let's say you own stock trading at ₹50 per share. Accordingly, your stop loss would be set at ₹45 — ₹5 under the current market value of the stock (₹50 x 10% = ₹5).
