Percentage Stop Loss
One of the easiest ways to set an initial stop loss is to use a percentage fall.
In other words, after entry, you are prepared for the price to fall a set percentage and if it does, that triggers your exit.
A common figure that is used (primarily because it is easy to calculate) is 10%.
As an example, we purchase XYZ Corporation at $2.20, and we use a 10% initial stop loss.
We can either work out what 90% of the entry price is (100% of the price minus our 10% stop loss) or work out what 10% is and then subtract this from the entry price.
Using the example detailed above, the exit price is calculated as either 90% of the entry price, therefore:
Initial stop loss
= $2.20 x 0.9 (90%)
Initial Stop Loss
= $2.20 – 0.1 (10%) x $2.20
= $2.20 – $0.22
So in the above example, our initial stop loss for our trade with an entry price of $2.20 would be $1.98.
Whilst 10% is an easy round number to use (and calculate), you can use any range of numbers, eg. 5% – 15%. Let’s consider the ranges for a moment.
If you use a 5% initial stop loss, you are obviously not allowing your stock to fall as far before you consider it a loser and exit the trade at a loss. This can be a disadvantage as you are potentially not allowing your stock the freedom to move above normally and perhaps continue its medium term trend.
On the other side, if you use a 15% initial stop loss, you are providing the stock ample opportunity to move in your anticipated direction before you consider it a loser and exit the trade at a loss. This can be the obvious advantage from the previous 5% method.
Let’s consider the 15% initial stop loss for a moment then – you might be reading this and think “but if I give back 15% before I exit, I am going to lose more money!”
Fair comment – however it depends.
If you commit an equal amount of money to each trade, then yes, you are correct. Having your initial stop loss further away will result in a greater loss.
However, using a better position sizing model, ensures that regardless of how far your initial stop loss is away, you only lose the same amount of money. This is what money management is all about.
An advantage of using a percentage initial stop loss is clearly that it is easy to calculate and use. A disadvantage is that it doesn’t tailor the position of your initial stop loss to the volatility (risk profile) of the stock.
In other words, if stock ‘A’ was twice as volatile as stock ‘B’ and you used a 10% initial stop loss with both trades, I would argue that your stop loss with stock ‘A’ is ‘closer’, because it is more volatile and the 10% is not as far away based on stock ‘A’s normal behaviour.
If this method is so easy, then it makes you wonder why more people don’t use it and cut their losses. Let me reiterate – one of the most important things you can do trading is to cut your losses.
|“Learn to take losses. The most important thing in making money is not letting your losses get out of hand.”