Different Types of Stop Loss Approaches in Trading
Different Types of Stop Losses in Trading
If you ask any successful trader the formula for his success, you would hear all the mundane proverbial statements that those traders swear by. However, newbies have a hard time digesting the fact that immense trading success can come out of simple but boring rule-following.
Especially, one rule that all successful traders swear by and newbies ignore is cutting the trading losses short when they are small.
Losses are painful. Nobody wants them because it’s an acceptance of being wrong and being wrong is a psychological evil. But, successful trading entails taking losses, a lot of them in fact.
Therefore, it's vital for all the traders to make peace with losses.
Taking losses isn’t as straightforward as it sounds. One must have rules to determine when the trade has gone sour to not kill a trade prematurely. Rules are essential to determine stop-losses, because, without rules, emotions will dominate your decision making, which will hardly produce the right outcome.
To help you with that, here are some frameworks that can help you formulate a few stop-loss rules for your trading.
Initial stop loss after entering a trade.
Your initial stop loss must be decided before entering the trade. You must set this stop loss keeping in mind the kind of reward you are gunning for.
Your percentage stop loss on any trade should be half or less of what you expect to gain from the trade. Under no circumstance, the stop loss should be higher than your average gain in your winning bets.
The best traders set their stop loss based on technical analysis. They observe how the chart has set up and determine their stop loss based on price breaching critical levels or the price behaviour becoming abnormal.
For example in the chart below, the ideal buy point for a breakout trader would have been when the price closed at a new high, with the stop loss close to the support zone towards the low of the set-up.
Sometimes the set-up would not have a low-risk entry point and the support zone could be too far from the buy price, in which case, you can set an absolute percentage as stop loss (not my recommendation). The absolute percentage, in this case, can simply be the average stop loss from your own historical trading.
Time stop: Avoid non-moving trades
Taking stop loss is easy when the price breaches a pre-determined level in a quick fashion. However, the price doesn’t always follow that path.
There are times when the price keeps on consolidating without breaching your stop loss level. Under such circumstances, It could be wise to keep a time stop, after all time is money.
A time stop could be used when the stock doesn't show a meaningful gain and also doesn't breach the initial stop loss level in a stipulated time.
I use the MACD cross down in our strategy for this reason, it takes away the risk of a trade losing momentum.
Different traders set different time frames for time stop depending on their trading timeframe. For example, a positional trader would give more time for the trade to perform than a swing or intraday trader.
Trailing stop: Protect profits
Trailing stops are a way to protect profits when you have decent gains on your trade.
Trailing stops are mostly based on how much profits are you willing to sacrifice to see a much bigger gain. Keeping a too tight trailing stop can choke the trade prematurely and can be detrimental, especially if you depend on a few winning trades to make most of your returns.
Some traders keep trailing stop losses based on a multiple of risk they took on the trade. For example, if you entered a trade with a 6% stop loss and you are making a 24% return, which is 4x of your initial risk, you can set a trailing stop of 2x or 3x your initial risk depending on how much return you are willing to sacrifice.
Some traders also keep it simple by determining the trailing stop as an absolute multiple like multiples of 5 or 10%. For example, a trader who is 40% in the money on a trade may keep a minimum 30% profit threshold and exit when the price declines and the profit comes down to 30%.
Again the MACD acts as a trailing stop and can be a great option.
Break-even: Don’t turn a winner into a loser.
There are times when the price moves in your favour and you are at a decent profit right away, but rather than following through on the move, the price turns and reaches your entry-level.
In such cases, protecting the break-even could be a consideration. As a trader, you can’t wish or hope for the price to go back and you should exit at the first sign of an abnormal reaction. In my approach abnormal means the MACD cross down.
There may not necessarily be anything wrong with your entry or the security, but it could be prudent to protect your break-even or raise the stop loss to give the trade a fresh look after the reversal or lack of momentum occurs. Many times the overall market turns and the security, despite its good characteristics, can follow the markets and deliver lackluster returns in the immediate term.
As Mark Minervini puts it “never let a decent size gain turn into a loss”.
And don't forget how a losing trade can work exponentially against us...
Stop losses are like paying an insurance premium to save yourself from bigger casualties. It’s the cost of trading and requires immense discipline to be executed properly time and again, especially when you are amidst a losing streak.
Stop losses are not sacrosanct and there will always be times when you exit at a loss only to see the price reverse and move without you. However, that shouldn't deter you from following the discipline. Rather than beating yourself up on the exit, you must congratulate yourself for following your rules.
Good trading is less of technique and strategy and more of discipline. It takes a lot of grind before you can make regular returns from trading. The grind almost always starts with learning to take losses and protecting your capital. Once you learn this, you can be much more aggressive when the opportunity presents itself.