Why Is Setting Your Stop Loss So Vital?

Discover the best ways to calculate your stop loss.

Provided By Trading Secrets Revealed

The way I go about setting my stop loss for longer term systems is by using a volatility based stop. The reason I’ve used this type of stop loss order 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 beyond the immediate noise of the market. I personally find this the most effective.

So, let me show you how I go about calculating my stop loss.

The way in which I measure volatility and set my stop loss is by using the average true range. Now, you can get the value of the average true range out of most charting packages. Very simply, though, the average true range is a measure of volatility. It indicates how much a stock will move on average over a certain period.

So, if you had a one dollar stock that moved five cents on average over the last 20 days, that doesn’t tell us whether the stock is going to move up or down. It just tells us on average how much the particular stock moves. The average true range really is a fantastic tool and can be utilized in your trading for more than just setting your stop loss. So, if you’re not familiar with it, I recommend you do a little bit of research because it can be a great tool.

So, how can we use this indicator in calculating our stop loss? All you do is you subtract a multiple of the ATR from the entry price. I might take two times the ATR and subtract it from my entry price. Now, what that means is if you look at the example I just touched on before, if we had a one dollar stock and its ATR value was five cents, I would simply take a multiple of the ATR which I said we’ll use two in this example, and we’d subtract it from our entry price. So, two times our ATR is ten cents, subtracted from our entry price gives us a stop loss value of 90 cents.

Now, by adhering to this pre-defined point at which I set my stop loss, I know that if the share price doesn’t move in my favored direction, and actually moves against me, I already know the point at which I’m going to sell. My emotions are removed from the equation, and I just simply follow what my stop loss says. This is how most successful traders limit their losses. They know when they’re going to sell and they have this pre-defined before they even begin trading. Although their methods of calculating this stop loss may be different the one common element here is that they have a stop loss in place.

Here’s a little extra finesse point that you might look at including in your trading plan. I sometimes introduce my stop loss depending on the type of system I’m trading. This type of stop loss simply takes you out of a position after a fixed amount of time if I haven’t made enough profit.

To successfully implement this type of stop loss, you’re going to have to do some sort of back testing, to find out if it’s appropriate for the particular instrument you’re trading. I just thought I’d throw that in there to make sure you have all your bases covered.

When you first begin outlining your stop losses, just keep in mind what Tom Baldwin, the successful trader said. He said the best traders have no ego. You have to swallow your pride and get out of your losses. He’s simply referring to having a stop loss set, and more importantly, having the discipline to stick to your perarranged stop loss.

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