Setting Stop Losses

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Introduction

We're talking about managing risk, so now we'll talk about another important aspect of money management - setting stop losses.  Many trading strategies have a success rate of less than 40%, but good money management can actually make these strategies profitable.  Cutting losses and letting profits run is a fundamental criteria of trading and managing stop losses allow us to make sure we have a plan to cut these losses at the right time.  By combining our risk rule of committing < 2% of our capital and setting a stop loss position we can then go on then determine the position size we can take for each trade.

There are many ways to determine stop loss positions.  As we've learned in previous modules some stop loss positions can be set under the last trading periods open (or over the last periods open if going short), under moving averages, trend lines, support and resistance levels and by using Parabolic SAR.  There are other ways however and we'll explore some of them below.

Setting Stops using Volatility - Using Average True Range to Set Stop Losses


Having an idea of how much the market is likely to move in the day-to-day noise of the market is always a good idea.  Understanding this volatility can be used to set stop loss positions. If you're trading a stock that moves €/$/£ 2 a day, or a stock that trades €/$/£ 1 a day, your stop loss may be wider on the former.  But how can you determine the volatility of a market.  We use the Wilder's ATR (Average True Range) indicator.  By using this indicator we prevent getting stopped out too soon on the more volatile markets.

Wilder's ATR is calculated for you on most charting platforms and is generally plotted in a 14 look back period moving average.  ATR is charted (as below) in a box below the main candlestick price chart, when the candles (price action) become longer the ATR moves higher (over it's look back period) and when the candles get smaller the ATR declines - This represents volatility.  Using the ATR will allow your trade to breathe and stop volatility stopping you out too quickly.  The most basic way to place your stops is to simply add or subtract the ATR from your entry point depending on whether you're going short or long. In our below chart example we've doubled the most recent ATR value and added to the short entry price. 

EUR/USD - Average True Range (ATR) to Calculate Stop Loss

Example:  A simple stop loss as indicated from the above chart where current ATR is 0.01222.

  • Sell EUR/USD 1.30338 (current price)
  • Stop Loss placed 2 x ATR above current price = 1.32782
(Rem. This is a simple example.  In reality we may wait for the down trend to retrace back to resistance before trading and wait for a trade confirmation)

Setting Stops using Support and Resistance

The Stop Loss Metaphor

I had a wild ride in June: balance opened with 2 big gains. Because I was mostly shorting stocks, a week of rising markets plunged me back to break even for the year. Then, finally, blessedly, groking that the markets had turned, I closed shorts and bot long. Barely ended the month with a gain on 4 days of gains. On reflection, I saw that having stops or limits on my orders would have preserved over $1000 of my balance. 

So, I asked myself, what's behind *not" using these tools? One experience came to mind immediately: trading the market w/o S&L feels "freeer" and more "masterly." S&Ls feel like training wheels! I had some success with S&Ls long ago when I knew I was going to away from daily attention to markets and wanted my holdings to stop out in case the market dropped. That is indeed what the markets did, and I was very happy to have put in those stops while away.

My experience with training wheels is that they were an annoyance and symbol of many things wrong with my relationship with my dad. When I was 5 or 6, as the first born child, he bought me a bike that fit him! Rather than getting a smaller one, I literally had to grow up to 11 or 12 to be larger enough to ride it. I had brothers (with smaller, kid-sized bikes) riding 2-wheels before I did. I vividly remember the day of no return when I took off those training wheels and mastered the #$^$ thing!

Even today, 40 odd years later, I can feel the heat of the blushing and shame - I was big and old enough, but could not ride a bike. So, clearly, this metaphor doesn't help. I have several options, one of which is to find a therapist and work this thing through. Another, and faster-cheaper option is to change the metaphor.

Some come to mind: S&Ls are ...

Nets, like those used by high-wire acts.
Life preservers, like those worn when white water rafting
Air bags, like those that deploy when cars hit thingsI might work with these. Don't feel any blushing, shame.

I WANT to use a life preserver on a white water adventure! I like this one best of the three, also, because rafting is a mix of turbulence I navigate with my actions (some skillful, some not). Should the preserver be needed, it ought to help me stay alive so I can take another trip.

Thanks for reading. This has helped.

Written by Feng
We've mentioned this previously in other modules, but let's take a proper look now.  Traders may want to utilise support and resistance levels to place stop/loss positions. Ideally a trader will place the stop just outside the support or resistance level. The thinking is that support or resistance will be hard to break for the market psychologically, but just in case this sentiment cracks we should cover ourselves with an insurance.

In the below chart we have trending support and resistance.  Going short at resistance (A) with a target at the opposite support (B) is a 693 point target.  If our strategy has a reward to risk ratio of 3:1 then our stop loss can be as high as 231 points, so anywhere between 10490 and 10721.  

Simple Stop Outside Support or Resistance

But just how far outside support or resistance should the stop/loss be placed?  This is an important question given that support and resistance can be broken easily with market spikes.  If your stop/loss is a point over support or resistance then you may be stopped out with one of these spikes. As an extra measure we can incorporate The ATR.

In the below EUR/USD chart we can see how incorporating The ATR with support and resistance can help place stops. Entering long at (A) when the market hits support at 0.965 with a target of 0.99 when resistance is expected at (B). This is a 250 pip target (0.990 - 0.965 = 0.025, which is 250 pips in this EUR/USD case). If our strategy incorporates a 2:1 reward to risk ratio then our stop can be placed anywhere up to 125 pips away from entry.  The 1 x ATR places our stop 115 pips away, well within our strategy rules.  However if our strategy was a 3:1 reward to risk ratio we would not trade on this occasion as our stop can only be placed 75 pips below entry (reward 225 / 3 = 75 pips)

Support/Resistance and ATR to place Stop

The level of ATR to use is up to you and should be tested as part of your on going trading strategy.  You may want to use 2 x ATR as in our volatility section above, or 1/2 ATR.  Look how in mid September volatility spiked the market below support.  If our target had not been reached and we were still in the market then we wouldn't have been stopped out, if we hadn't incorporated volatility into our thinking.

For another example of combining The ATR with Moving Averages to determine stop loss positions see "Trading System Scribblings - A Swing Trade"

Stop/Loss Mistakes

  • Always use a stop/loss position
  • Don't place tight stop positions.  Always remember volatility as measured by ATR or some other volatility measure.  Your trade needs room to breathe.
  • Don't use position size to set stops. ALWAYS set your stop via technical analysis THEN calculate your position size by incorporating your risk
  • Don't place your stop too far away from entry price just because your strategy says so.  This increases money management failures and may not fit in with your reward to risk ratio. Whatever your trading strategy you generally want to get as close to the bottom or top of a move. If it's not doing that then placing a larger stop will not help you with managing your risk. Consider this concept. The slower you are in getting into the market the larger your stop out has to be. So the amount you can lose or the amount you are "risking" if you are wrong is larger.
  • Don't set stops exactly on support, resistance, trend lines.  These lines are "area", so have a little leeway acting as support and resistance.  
  • Try to accept your losses as part of your strategy.  NEVER delete the stop thinking the market will turn back soon. Once the trade reaches your stop then the trade is no longer valid.
more...


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Introduction

We're talking about managing risk, so now we'll talk about another important aspect of money management - setting stop losses.  Many trading strategies have a success rate of less than 40%, but good money management can actually make these strategies profitable.  Cutting losses and letting profits run is a fundamental criteria of trading and managing stop losses allow us to make sure we have a plan to cut these losses at the right time.  By combining our risk rule of committing < 2% of our capital and setting a stop loss position we can then go on then determine the position size we can take for each trade.

There are many ways to determine stop loss positions.  As we've learned in previous modules some stop loss positions can be set under the last trading periods open (or over the last periods open if going short), under moving averages, trend lines, support and resistance levels and by using Parabolic SAR.  There are other ways however and we'll explore some of them below.

Setting Stops using Volatility - Using Average True Range to Set Stop Losses


Having an idea of how much the market is likely to move in the day-to-day noise of the market is always a good idea.  Understanding this volatility can be used to set stop loss positions. If you're trading a stock that moves €/$/£ 2 a day, or a stock that trades €/$/£ 1 a day, your stop loss may be wider on the former.  But how can you determine the volatility of a market.  We use the Wilder's ATR (Average True Range) indicator.  By using this indicator we prevent getting stopped out too soon on the more volatile markets.

Wilder's ATR is calculated for you on most charting platforms and is generally plotted in a 14 look back period moving average.  ATR is charted (as below) in a box below the main candlestick price chart, when the candles (price action) become longer the ATR moves higher (over it's look back period) and when the candles get smaller the ATR declines - This represents volatility.  Using the ATR will allow your trade to breathe and stop volatility stopping you out too quickly.  The most basic way to place your stops is to simply add or subtract the ATR from your entry point depending on whether you're going short or long. In our below chart example we've doubled the most recent ATR value and added to the short entry price. 

EUR/USD - Average True Range (ATR) to Calculate Stop Loss

Example:  A simple stop loss as indicated from the above chart where current ATR is 0.01222.

  • Sell EUR/USD 1.30338 (current price)
  • Stop Loss placed 2 x ATR above current price = 1.32782
(Rem. This is a simple example.  In reality we may wait for the down trend to retrace back to resistance before trading and wait for a trade confirmation)

Setting Stops using Support and Resistance

The Stop Loss Metaphor

I had a wild ride in June: balance opened with 2 big gains. Because I was mostly shorting stocks, a week of rising markets plunged me back to break even for the year. Then, finally, blessedly, groking that the markets had turned, I closed shorts and bot long. Barely ended the month with a gain on 4 days of gains. On reflection, I saw that having stops or limits on my orders would have preserved over $1000 of my balance. 

So, I asked myself, what's behind *not" using these tools? One experience came to mind immediately: trading the market w/o S&L feels "freeer" and more "masterly." S&Ls feel like training wheels! I had some success with S&Ls long ago when I knew I was going to away from daily attention to markets and wanted my holdings to stop out in case the market dropped. That is indeed what the markets did, and I was very happy to have put in those stops while away.

My experience with training wheels is that they were an annoyance and symbol of many things wrong with my relationship with my dad. When I was 5 or 6, as the first born child, he bought me a bike that fit him! Rather than getting a smaller one, I literally had to grow up to 11 or 12 to be larger enough to ride it. I had brothers (with smaller, kid-sized bikes) riding 2-wheels before I did. I vividly remember the day of no return when I took off those training wheels and mastered the #$^$ thing!

Even today, 40 odd years later, I can feel the heat of the blushing and shame - I was big and old enough, but could not ride a bike. So, clearly, this metaphor doesn't help. I have several options, one of which is to find a therapist and work this thing through. Another, and faster-cheaper option is to change the metaphor.

Some come to mind: S&Ls are ...

Nets, like those used by high-wire acts.
Life preservers, like those worn when white water rafting
Air bags, like those that deploy when cars hit thingsI might work with these. Don't feel any blushing, shame.

I WANT to use a life preserver on a white water adventure! I like this one best of the three, also, because rafting is a mix of turbulence I navigate with my actions (some skillful, some not). Should the preserver be needed, it ought to help me stay alive so I can take another trip.

Thanks for reading. This has helped.

Written by Feng
We've mentioned this previously in other modules, but let's take a proper look now.  Traders may want to utilise support and resistance levels to place stop/loss positions. Ideally a trader will place the stop just outside the support or resistance level. The thinking is that support or resistance will be hard to break for the market psychologically, but just in case this sentiment cracks we should cover ourselves with an insurance.

In the below chart we have trending support and resistance.  Going short at resistance (A) with a target at the opposite support (B) is a 693 point target.  If our strategy has a reward to risk ratio of 3:1 then our stop loss can be as high as 231 points, so anywhere between 10490 and 10721.  

Simple Stop Outside Support or Resistance

But just how far outside support or resistance should the stop/loss be placed?  This is an important question given that support and resistance can be broken easily with market spikes.  If your stop/loss is a point over support or resistance then you may be stopped out with one of these spikes. As an extra measure we can incorporate The ATR.

In the below EUR/USD chart we can see how incorporating The ATR with support and resistance can help place stops. Entering long at (A) when the market hits support at 0.965 with a target of 0.99 when resistance is expected at (B). This is a 250 pip target (0.990 - 0.965 = 0.025, which is 250 pips in this EUR/USD case). If our strategy incorporates a 2:1 reward to risk ratio then our stop can be placed anywhere up to 125 pips away from entry.  The 1 x ATR places our stop 115 pips away, well within our strategy rules.  However if our strategy was a 3:1 reward to risk ratio we would not trade on this occasion as our stop can only be placed 75 pips below entry (reward 225 / 3 = 75 pips)

Support/Resistance and ATR to place Stop

The level of ATR to use is up to you and should be tested as part of your on going trading strategy.  You may want to use 2 x ATR as in our volatility section above, or 1/2 ATR.  Look how in mid September volatility spiked the market below support.  If our target had not been reached and we were still in the market then we wouldn't have been stopped out, if we hadn't incorporated volatility into our thinking.

For another example of combining The ATR with Moving Averages to determine stop loss positions see "Trading System Scribblings - A Swing Trade"

Stop/Loss Mistakes

  • Always use a stop/loss position
  • Don't place tight stop positions.  Always remember volatility as measured by ATR or some other volatility measure.  Your trade needs room to breathe.
  • Don't use position size to set stops. ALWAYS set your stop via technical analysis THEN calculate your position size by incorporating your risk
  • Don't place your stop too far away from entry price just because your strategy says so.  This increases money management failures and may not fit in with your reward to risk ratio. Whatever your trading strategy you generally want to get as close to the bottom or top of a move. If it's not doing that then placing a larger stop will not help you with managing your risk. Consider this concept. The slower you are in getting into the market the larger your stop out has to be. So the amount you can lose or the amount you are "risking" if you are wrong is larger.
  • Don't set stops exactly on support, resistance, trend lines.  These lines are "area", so have a little leeway acting as support and resistance.  
  • Try to accept your losses as part of your strategy.  NEVER delete the stop thinking the market will turn back soon. Once the trade reaches your stop then the trade is no longer valid.
more...


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