Setting Good Stop Loss Orders

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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 don’t know at one point we’re 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, it’s 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 hasn’t done what we thought it was going to do, therefore we’ll 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 here’s why – psychologically humans are hard wired into believing that they must be right. When 95 percent of traders enter into a position, they’re 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. It’s almost like we have an ejector seat that tells us when to abort the mission.

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 you’re trading. If you’re a shorter term trader, you’re going to have to be prepared to give the stop loss orders when your stock nears its original price. Whereas, if you’re a longer term trader, you’ll actually give the share price a little bit more room to move by setting your stop loss lower.

Once you’ve identified what time frame you’re looking at trading, the next step is to be able to remove the normal market noise in that particular time frame. You don’t 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 you’ll 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 doesn’t 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 you’d 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 I’ve 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, I’m 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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