Types of Stop Losses
You are going to have many occasions when you open a position and it moves in the opposite direction to what you had anticipated. A key issue as a trader is to realise and accept that losses are a normal part of trading. It is essential however, that you follow the time tested rule of ‘cutting your losses’.
A ‘stop loss’ is a pre-defined level at which you will exit a position in a security based on the premise that it is not moving in the direction that you had anticipated.
All experienced and successful traders will tell you that setting stop losses and then sticking to them, is absolutely essential if you are going to be profitable over the long term.
Fortunately, there are a number of different ways of determining suitable stop loss points and they all have their own strengths and weaknesses when compared with each other. There are also a number of different factors that will influence the way in which you determine your stop loss level including your tolerance to risk and more importantly the time frame over which you consider trends.
As an example, a trader who trades over the short term perhaps using options or futures will place his/her stop losses a lot closer to the price than another trader who trades over the medium term. The medium term trader will place their stop loss further away from the price in order to allow the medium term trend to move naturally.
There are a number of different ways of selecting a stop loss point. The following methods would be the most common:
You can set your stop loss level based on losing a set percentage of the position. For example, if you used a 10% stop loss, your stop loss level would be placed at 10% off the position entry price. This is a very simple method but does not consider the volatility of the security you are trading. Click here to read more.
You can set your stop loss level using technical analysis. For example, you could determine at what point on the chart you will change your opinion on the likely direction of the security. This could be breaking below the previous trough or failing to form a higher peak. Click here to read more.
You can set your stop loss level based on the security’s normal trading behaviour. Ideally a volatility stop loss will use Average True Range but could also use Standard Deviation. Click here to read more. Click here to read more about Average True Range.