A stop-loss order is a must for day traders. You should always use a stop-loss order to prevent slippage.
The Key Takeaways
- Stop-loss orders are an alarm system for trading stocks. They can be used to pull the plug if you’re not sure about the direction of the market.
- If they are correctly calculated and placed, stop-loss orders may be very effective. When a stock falls below your threshold, it will be removed.
- Stop-loss can be calculated based on the number of ticks, cents, or pips at risk or the dollar amount at risk.
- For all trades, the same stop-loss order will not work. These are highly individual, but it can be worthwhile to do the math. Calculate the chances of your loss or profit with a probability calculator.
Correctly placing a stop-loss
Stop-loss strategies are those that place your stop-loss in a spot where you can be wrong about the direction the market is heading. It is unlikely that you will be able to time all of your trades perfectly. The stock price will not always go up immediately after you purchase it, no matter how much you wish. When you buy, allow the trade to move a little before it begins to rise. A stop-loss can be used to exit a trade if the price falls so far that it is impossible to avoid any loss. Find the probability calculator online.
A good rule of thumb is to place your stop-loss price at a price lower than the most recent low price (a “swing low”) when you purchase stock. The price bar that you choose to place your stop loss below will depend on the strategy. However, this is a good stop-loss spot because the price has bounced off of that low point. If the price falls below this low, it could be an error in your assessment of the market direction and you will know when to exit the trade. It is helpful to examine charts and search for visual cues.
A general rule of thumb is to place your stop-loss at the top of a recent high price (or “swing high”) when you are short-selling. The price bar that you place your stop loss above will depend on the strategy. However, this is a good location for a logical stop loss, since the price has dropped from that high. Similar to finding the swing low, you can study charts to find the swing high.
Calculating your Placement
There are two ways to calculate your stop-loss placing: account dollars at risk or cents, ticks, or pips at high risk. The account-dollars at Risk strategy provides more information because it allows you to see how much of your account was involved in the trade.
You should also note the ticks, pips, or cents at risk. However, it is better to simply relay information.
If your stop is at X and your long entry is at Y, you can calculate the difference using these steps:
Y = cents/ticks/pips at Risk
You have six cents at stake per share if you purchase a stock for $10.05 and set a stop loss at $9.99. You can take 6 pips per lot if you short the EUR/USD currency pair at 1.1569 with a stop loss at 1.1575
This number is useful if you need to tell someone where your orders are or how far your stop loss is from your entry price. This figure does not show you or anyone else how much of your account was risked by the trade.
You will need to know how much of your account is at risk. This includes the number of cents, ticks, or pips, as well as your position size. You have a $0.06 risk per share in the stock example. Let’s suppose you have 1,000 shares in your position. Your total risk for the trade is $0.06 x 1,000 shares or $60 (plus any commissions).
A future position has a dollar risk. However, instead of using a pip value, you would use a tick value. You are putting a stop loss at 1,253.25 on the E-mini S&P 500 (ES), and 5 ticks of risk. Each tick is worth $12.50. You would calculate your dollar risk if you bought three contracts:
5 ticks X $12.50/tick X 3 contracts = $187.50 plus commissions
Take control of your account risk
Your total trading account should have a very small amount of dollars at risk. The amount at risk should not exceed 2%, or even 1%, of your total account balance.
A forex trader might place a stop-loss order of 6-pip and trade 5 mini lots. This would result in a $30 risk. If they risk 1%, it means that they have risked 1/100. How big is their account if they are willing $30 to trade? This would be $30 x 100 = 3000. The trader must have at least $3,000 in his account in order to risk $30.
You can quickly change the direction to find out how much you are willing to risk per trade. You can risk $5K / 100 if you have a $5,000 account. This is $50 per trade. You can trade up to $300 per trade if your account balance is $30,000 (though you could choose to risk less). A good rule of thumb is to place your stop-loss price at a price lower than the most recent low price (a “swing low”) when you purchase stock. The price bar that you choose to place your stop loss below will depend on the strategy.
The bottom line
Always use a stop loss. You can also examine your strategy to determine the best place for your stop-loss orders. Your ticks, ticks, or cents at risk can vary depending on your strategy. This is because each trade should have a stop-loss placed strategically.
If you have incorrectly predicted the market’s direction, the stop-loss must be reached. Your cents, ticks, or pips at loss on every trade are important calculations that will help you calculate your dollars at danger. This calculation will guide your future trades and is much more important than the one above. You should keep your dollars at risk for each trade to less than 1% of your trading capital. This will ensure that any loss, even a series of losses, won’t significantly deplete your trading account.