What is stop loss and how to use it?
This is the most common problem among traders. How to set stop loss to protect position but not to be stopped out too soon? The good news is that setting stop losses with Fibonacci trading tools is easier. In this article you can read about basics of setting stop losses and some more advanced tips.
Should you use stop loss orders?
Lately I’ve read few opinions that using stop losses is bad. I am not going to fight with everybody here. If some pro trader thinks that stop losses are not necessary then it is his choice. If he makes money, that is good. But if you are a new investor, struggling to close a year with a profit, than using stop losses is necessary.
Let’s say it clear and loud: stop losses are not perfect. It is not something that will make you rich or profitable trader. It is also not something 100% accurate. You set your stop losses and your stop losses are as good as good trader you are.
Why stop losses are good?
Stop losses are good because they protect you from your grid and impulsive decisions. How many times have you waited too long to close the losing trade? You were hoping that this is only a correction and in a minute buyers will come back.
Emotions are your worst advisor. You cannot turn them off totally, but you can work on minimalizing their impact on your trading. Stop loss order is one of the tools which may help you to achieve that.
The idea of stop loss
The idea of good stop loss placing is to help you keep your losses small and avoid emotions taking control over your decisions. This way you can have three losing trades in a row, but your loss together from these three trades won’t be such a big. The next trade may be much more profitable.
Let’s look at example.
John wants to buy 200 shares of YYY Company at 12$. He is willing to risk 1.2$ on each share. He has a good feeling about this company and his trading plan gives him a green light. He bought it and two days later he was stopped out. His lost was 1.2$x200 shares = 240$.
Next day he decides to enter other trade. There was a breakout on VVV chart. He buys 80 shares at 20$ and set his stop loss 1.5$ lower. In the beginning it looks good, but suddenly there is a rumor about YYY problems and shares start to fall. He was stopped out. His loss is 1.5$x80 shares = 120$.
He is not happy about that, but he is looking at other opportunities. He has few possible candidates, but he decided to wait for another confirmation from his trading plan. Few days later there is a confirmation signal on HHH Company’s chart. He buys 50 shares for 42$ and sets his stop at 38.5$. There is not too much action next days, but eventually stock starts to move up.
In next few weeks HHH goes up to 52$ and John decide to close the trade, because there is a strong resistance near that level. He closes position at 52$ and his profit is 50 shares x (52$-42$) = 500$.
On previous two trades he has lost 360$, so his profit is 500$-360$=140$. Ok, he is not reach, but it is not so bad. But what if his losses from previous trades were bigger? Then he still would be trying to earn back his money.
Example is pretty simple, but I hope that you get the main idea. That is a life of investors. You will be stopped out. Your goal is to look for profitable trades and thanks to them earn money for profit and to cover your losses.
There is a very popular goal to keep your risk/reward ratio at 1:2 or even 1:3 proportions. That means that trader is willing to risk for example 2$ per share and expect to earn 4$ per share (1:2) or 6$ (1:3).
If the risk/reward ratio is around 1:1, they do not enter a trade because it is not worth that risk.
Risk/reward description is a good topic for another article. For now let’s stay with the risk part. Experienced traders, who are looking for good opportunities, know where to put stop. They do not enter a trade and then wonder: “Hmm, maybe here will be a good place for stop loss”. They basically know that when they think about entering a trade, because they are looking for good risk/reward ratio. Keep that in mind.
When to set stop losses?
The best practice is to set stop loss in the same time you are placing your order. You should know in advance where you want to set your stop loss. When you are placing your order, you set stop loss right way. Why? Because later you are probably going to hesitate to place SL. You might also place it in a wrong place, because of emotions.
Where should you set stop loss?
It is hard to answer in few words, but there are some good rules you can follow. Before we review them, let’s learn more about two most common mistakes.
Mistake 1: Placing stop too tight.
When stop loss is set too tight then there is a strong chance that you will be stopped at first bigger move or stop hunt. Markets are very volatile today and it is easy to be stopped out when your stop is too close.
I’ve noticed that this happens to traders who do not want to lose too much money. Because stop loss is very near the entry point, when it gets triggered, loss on account is small. The main problem is that tight stop losses get triggered very often. Soon you have dozen of small losses which altogether are one huge loss on your account.
Mistake 2: Placing stop too wide.
Nobody likes to be stopped out from a trade. Some traders place their stop losses very wide to avoid that. They do not want to be caught during stop hunting or correction. Wide stop losses are triggered rarely, but when it happens – loss is very big.
On some occasion that works, but on many times they are eventually stopped out and loss from that is very big.
So what is the answer here? You have to find something in the middle! Ok, I know that this is not the answer ;).
Start from looking closely at price action. If you have read my others articles, you saw the next chart, but this is an answer for your problem.
I assume that you are trying to invest in a trending market. When there is no trend, you do not trade. What we know is that in an uptrend we have a sequence of higher highs and higher lows, just like on the chart. If the trend is strong and healthy, you can easily see that sequence just looking at the price. When there is something wrong with trend, price has problem to make next high – sign that correction is possible.
With all that information you can place your stop below last significant low, when you are in a long position. When trend is healthy, you should make your money. When trend is very weak, you will be stopped out. It is a good thing because probably the price will go even lower than your stop loss.
It also works in a downtrend. You are simply looking to place your stop loss above last high.
Look at the logic here. If price in a downtrend will manage to break above recent high, then there is a strong chance that buyers are trying to take over the control. You do not want to be short in that situation. You want to close your position and look for other opportunities.
Raising stop loss
I am a huge fan of that method, yet many people do not use it. It is very simple, so in your next trades try to use it.
How does it work? You place your stop loss when you are opening a trade. On some occasions you will be stopped out pretty fast. Other times trade will go as you wanted to. That is good, but what do you do when your trade is profitable? It still can turn around and trigger your stop loss and from profitable trade you will end with a loss. That was my mistake actually for many years. I had so many profitable trades for a while, but I was closing it with loss.
Now when my trade is profitable, I am simply raising my stop loss to the entry point. This way even if price is going to turn against my position, I do not lose a single dollar.
When to raise stop to entry point? Not as soon as your trade is profitable. Just wait some time and see how things are. You have to work out your own system. I usually wait until price is at least twice as far from entry point as my stop loss is. So in a trade where entry position was at 20 and stop loss set at 18 (2$ lower from entry price), I raise stop loss to 20 as soon as price will go up to 24$ (twice as stop loss so 2×2$=4$).
Sometimes I raise it earlier – it really depends from situation.
When the price is still going up, I am raising my stop even further. Why? To protect my profit. If price will fail to reach my target, I still book some profit from that trade. It is called trailing stop, because your stop loss is practically following the price all the time. When price goes up, so is your stop loss. Of course if price in an uptrend is down, you are not lowering your stop. There are many methods of using trailing stop loss. You can watch this movie below to see how some traders are using this technique.
Some traders are using 2% rule, but this is not the most important thing about that rule. 1% rule means that you can risk only 1% of your trading capital on any single trade.
For example, when your trading account is 20000$, than you can risk 20000$*1%=200$ on any single trade.
Yes, you can risk only 200$ per trade. Many traders do not have big enough accounts, so they are simply just ignoring this rule. The truth is, this is a great rule, which helps you to survive. Even if you will have 20 losing trades in a row, you still have more than half of money on your account. Without that rule, you would be probably looking for money for your next account.
It is very wide topic; I am going to write about this in separate article. It is your decision to use this rule or not. I am using this rule and I can say that on many times it saved my account.
Join this rule with good stop loss placing and you will be so much better trader.
Stop losses with Fibonacci trading
When you are trading with Fibonacci numbers, it is easy to use stop losses.
When I am looking to enter a long position, I wait for a correction to the retracement line. When I enter after some confirmation signal, my stop loss would usually go below 61.8% or 78% line:
When price will close below those lines, then I do not want to be in that trade because price should go up from these levels, not below them.
When I go long on breakout, then my stop loss goes below the nearest retracement line:
Why? Because I assume that trend is strong enough that last high was broken, so price should go up. When it does not, then probably there is something wrong with the trend or this is a false breakout. I take a small loss and wait for another setup.
Stop loss placing is an important topic. Many traders have different ways of doing that. You should work on your trading plan and practice different ways of placing stop losses. It comes with time, but it is worth it to practice. Stop loss can be a great tool in your trading and I hope that I’ve managed to show you that in my article.