Everything You Need To Know About Stop Loss Orders

I have a major complaint with most trading and investing education services.  My issue extends beyond just online courses and web sites, it goes deep into the very core of how stock market investing is presented by the so-called experts.

My grievance can spell the difference between profits and losses, not to mention why some are successful in the stock market while the vast majority simply break even or lose over the long term.

complaint

The complaint focuses on the fact that very little education or advice revolves around the most critical aspect of investing.  In fact, without this aspect, it would not just be difficult to earn profits investing, it would be impossible!

Investors are awash in information on how to pick and buy stocks.  Most of this information makes sense and can lead to profits.

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    Everything You Need To Know About Stop Loss Orders

However, the most critical profit making key is left out of the equation.  This key isn’t sexy or exciting.  You will rarely hear guru’s like Jim Cramer talk about it in public.  The gurus prefer to be known as stock pickers so they leave the critical truth out of the equation.

cramer

The critical truth is so simple yet not talked about near enough in trading education.

The truth is that profits cannot be earned or any money made until the trade is closed.  It is by closing the trade that profits are created and gains realized.

My gripe is that rarely do trading educators focus on this aspect of the trade cycle.

This article will explain the most common way to take profits, as well as how to protect your portfolio from further losses from those trades that just don’t work out.

Stop orders are the most common and effective way to take profits and protect your capital. There are 2 primary types of stop loss orders the fixed stop and the trailing stop.   First, let’s look at the fixed stop.

  1. The Fixed Stop

The fixed stop is a stop loss order triggered when a particular price is hit.  Fixed stops can also be timed based.  Fixed stops are most commonly used as soon as the trade is placed. Many successful investors simultaneously place the stop order when entering the order to purchase the shares.  This ensures that the risk is a known factor prior to the trade being executed.  Fixed stops are placed a fixed space (more on this later) away from the entry level to prevent further losses.

Another common technique to use fixed stops is setting them based on time rather than price.   Only utilize time-based stops when positioned sized properly to permit major adverse swings in price.  Time stops are useful for investors who want to provide the position a preset amount of time to profit prior to moving onto the next trade.

  1. The Trailing Stop

Trailing stops are my favorite way to take profits. Their function works to make certain profits are locked yet permits the trend to create additional profits.

What I like best about trailing stops is they allow the market move to work for you rather than against you. Trailing stops provide the potential to stay in a profitable position yet have the comfort of protected profits.  I like to convert fixed stops to trailing stops once a certain amount of profit is realized.

stop loss

Trailing stops are set to follow price by a certain distance. This is easier to understand by example.

An example would be that you purchased a stock at $8.00 per share.  Price eases higher to $11.00 per share, and your research reveals it could soar much higher.

You set a trailing stop order at $9.00 per share to assure profits regardless what occurs with the share price.  For every point that the share price moves higher, the trailing stop moves one point higher.

Meaning that when the price hits $15.00 per share, the trailing stop has automatically moved to $14.00 per share locking in the profits.  Now, at the same time, should price fall back by one point, the trailing stop will activate creating profits.

Don’t worry! You do not have to program or watch the trade non-stop to use trailing stops.  Most every online trading platforms has a trailing stop functionality already built in. 

online trading platform

Every trading platform is built a little differently on how to use the trailing stop function.  Learning how to use this function is critical for your success as an investor.  Study the user guide, ask questions of tech support and practice on the simulated trading feature to become an expert on this crucial key to success.

What’s The Best Distance to Set Stops? 

Most traders simply just guess when it comes to how far away to set stops both trailing and fixed.

The number is often chosen based on how much capital you are comfortable losing.  While this method can and does work, there is a far more optimal way to set the stop distance.

My favorite method of setting the stop distance is both statistically and practically based.   It is based on something known as Average True Range or ATR.

 atr calcu

Average True Range was first revealed by technical analyst Welles Wilder in his 1978 book, “New Concepts In Technical Trading Systems” 

ATR considers volatility but not the direction, strength or length of a move.

In this context, volatility refers to how much does the stock move in a given period. This is also known as its price range.  ATR is the average of the True Range.

True Range is the maximum of the current low and previous close, the difference between the present high and the last end, or the difference between the current low and the previous close

 The true range can reflect the greatest of the current low and previous close or the difference between the present high and the last close, or the difference between the current low and the previous close.

The average of the true range is then calculated over a set number of periods to determine the ATR.

The suggested number of periods used is 14. These periods can be weeks, days, hours, or even minutes.

The way you decide is based on the time frame that you are trading.

For example,  day traders use intraday periods for the 14 periods.

Longer term Swing traders  use days or even weeks as the time frame.

A high ATR number means volatility is high during the period; a low ATR means low volatility.

Fortunately, most trading platforms have the ATR feature already built into them.  There is no need to know the formula but for those who want to know HOW things work, here is the formula.

Here’s How To Use The ATR To Find The Optimal Stop Distance                   

 

  1. Determine the ATR of stock times it by 3

 

  1. Subtract this number from the entry price to determine where to set the initial

The reason this works is it keeps you in the stock during insignificant adverse movements.  Price needs to move 3X the ATR to be stopped out.

If you think about this, it makes sense.  You will only get stopped out if the stock makes a significant move that may be signaling a change in trend.

The best news is that the ATR is usually baked into online trading platforms so it can be calculated automatically.

One thought on "Everything You Need To Know About Stop Loss Orders"

  1. Mike says:

    Superb advice on initial + trailing stop. Sort of exponential formula (ATR(14)*13 + last ATR)/14 makes sense. Qestions:
    1) ATR is defined twice; first definition uses the value “end”. Is “close” meant?
    2) Initial stop position at 3 ATR seems exagerated even if will hopefully be reduced as soon as breakeven is reached. But having to use 3 ATR as SL will kill your position size if SL distance may not exceed 1% of available margin for proper money management . It seems that 1.5 x ATR should be enough
    3) Arithmetic is failing when calculating SL positionning. If trailing is placed at 9$ when price hots 11$, then distance is 2 not 1 as suggested when saying that trailing stop is at 14$ when stock hits 15$…
    In any case thanks a million for taking the time to help us.

  2. […] better way to set stops is to use the average true range (ATR) as we discussed in an earlier article.  The ATR is customized to the personality of each stock. The true range is the distance between […]

  3. Timber Rafthand says:

    As usual, spot on advice! (This is my first day on your site, so please forgive me if my question is irrelevant.) On the other hand, if in a fit of rational exuberance, should a crazy-like-a-fox investor consider doubling down and buying even more shares, when a good company, like Berkshire, is driven down, say, by 20%, because Mr. Market sometimes is irrational?

  4. Very useful article for traders. I wish to know more about it.

  5. Ric Mills says:

    Good article and information

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