Placing a Stop loss the RIGHT way

Stop loss orders are incredibly important in managing transaction risks, as is diversification and optimal asset exposure time-spans. So how do we place good stop loss orders?

• Usual approach - given an entry point at which I get into a trade I just place the stop loss p% below the buy price (where p depends on a recent volatility window, as measured by range or standard deviation)


• This is often a reasonable strategy as my entry point would be at some optimal price pattern (or fundamental land-mark) and hence the stop loss should be relatively well place.


• However it is quite a blind-folded approach... somewhat like a defender passing back to your own goaly without looking whether the goalie is really there - see this metaphor in action. Usually this would work, but it could cost you a lot if the goalie isn't there. Hence when placing a stop loss, make sure it is reasonably well placed. Bruce Konver sumarises this nicely in Market Wizards [pp. 65]: Whenever I enter a position, I have a predetermined stop. I know where I'm getting out before I get in. The position size on a trade is determined by the stop. If the market is in the midst of a trading range, it makes no sense to put your stop within that range since you are likely to be taken out. I always place my stopn beyond some technical barrier.

There are 3 important elements (or reasons) related to stop losses:

• The reason to place a stop loss by inspection rather than "blind" rule of thumb rule is not to get executed too easily when I as a trader strongly believe the market will move the opposite direction, however when I also want to avoid a loosing position in case my initial market conviction was faulty.


• The transaction size is determined based on the stop loss, the farther the stop loss the smaller the transaction size should be.


• The stop loss should not be static, it should change with price. To illustrate, I have a position that moves in my favour by quite a few points (maybe the initial stop loss - buy margin), now I want to hang on to this open position in order to ride the current trend for a little longer, but I also feel I want to protect my gains (this is the only safe way of trading a trend). I therefore move my stop loss to a higher price. So that 1st I protect some of my gains, and 2nd, the new stop loss is placed into a reasonably intelligent / significant price landmark, so that it does not execute with the next price swing, (the stop loss must be based on a good measure of volatily, I will run some empiricall experiments on this when I get spare time).