Good Stop Loss Orders
By Trading Secrets
Learn To Set Stop Loss Orders
The next area that we need to discuss is how to calculate our stop loss
and when to give our stop loss orders. The stop loss is simply the predefined
point at which we exit a stock. This exit point is determined before we
even enter the trade. Giving stop loss orders is when you tell your broker
to actually sell the diminishing stock. You see anytime that we enter
a position, we dont know at one point were actually entering into the
trend. We might be entering into a stock just before the trend changes.
Before we can give the stop loss orders, we need to set a stop loss. Effectively,
its like drawing a line in the sand underneath the share price, and we
say, If the share price falls below this line, then the stock hasnt
done what we thought it was going to do, therefore well exit the position
by giving our stop loss orders. This allows us to cut our losses short
and we all know how important that is, and heres why psychologically
humans are hard wired into believing that they must be right. When 95
percent of traders enter into a position, theyre expecting to profit
from this trade.
If, however, the share price goes against them, they feel they need to
justify why they bought this stock by holding onto it until it turns a
profit. However, you might have heard before, the idea that all big losses
once started as small losses. This just illustrates the need to have a
stop loss in place you must be prepared to give the stop loss orders.
Its almost like we have an ejector seat that tells us when to abort the
One of the most common questions I receive when traders first become introduced
to a stop loss is How wide should I actually set my stock and when should
I actually give the stop loss orders? Or in other words, how much room
should I give the stock to move? Unfortunately, there really are no definitive
answers here because it depends on what time frame youre trading. If
youre a shorter term trader, youre going to have to be prepared to give
the stop loss orders when your stock nears its original price. Whereas,
if youre a longer term trader, youll actually give the share price a
little bit more room to move by setting your stop loss lower.
Once youve identified what time frame youre looking at trading, the
next step is to be able to remove the normal market noise in that particular
time frame. You dont want to have to close out a position just because
a share price moved a little bit while part of its normal trading volatility.
There are some serious drawbacks from setting tight stops when giving
stop loss orders. Firstly, by having tight stops youll decrease the reliability
of your system because you get stopped out more often. Secondly, and probably
a little bit more importantly, by setting tight stops, you dramatically
increase your transaction costs. Transaction costs, when trading, make
up a major proportion of doing business.
To give yourself a fighting chance, you want to at least trade a system
that doesnt excessively chew through brokerage when you give your stop
loss orders. Consequently, this is one of the major reasons I steer my
clients into trading systems over a slightly longer time frame.
With that in mind, the question still remains, how can you go about setting
stop losses before the giving stop loss orders? Although there are many
ways to do this, the one real key here is just to have one in place. Some
of the different methods available are things such as your percentage
retracement where you allow share prices to retrace a certain percentage
of the entry price before you give the stop loss orders.
Other stops consult indicators to identify where your stop loss orders
are going to be set. You could also use support and resistance stops to
set the level at which youd exit. Although, personally, I find this a
little bit subjective, and I like to have a mechanical way of calculating
my stop loss orders. The way I go about setting my stop loss orders is
by using a volatility based stop.
The reason Ive used these types of stop loss orders is because I
believe that volatility usually represents market noise. Consequently,
if I have a way of measuring volatility, and I take a multiple of
that value and subtract it from my entry price, Im probably going
to have set my stop loss orders beyond the immediate noise of the
market. I personally find this the most effective.
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