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).

Catching the big Moves

Most trading seems to be sideways (I'll do an empiricall analysis sometime soon, when I get a spare moment), however at breakout points strong trending action tends to occur and this are the best places to get into positions with good stop loss order strategy. Especially then (with a loss limitting strategy) when you are wrong, it doesn't matter too much!! Famed trader Bruce Konver talks about this in Market Wizards [pp. 59]: Michael Marcus taught me one other thing that is absolutely critical - You have to be willing to make mistakes regularly; there is nothing wrong with it. Michael taught me about making your best judgement, being wrong, making your next best judgement, being wrong, being wrong, making your third best judgement, and then doubling your money.

I just experienced such a situation yesterday. Friday close & Monday open FTSE-100 rolling bet price was at around 4200 and I felt dead sure on selling short. Unfortunatelly I lacked the concentration & peace of mind to execute this trade, during the day the price fell down to 4000 with literally no big %tage up jumps that could trigger a good stop loss with reasonable bet sizes. With a 20 bet-per-point transaction size this would have produced a £4000 profit with only ever giving a virtual loss of around £500 during the trading day. The best thing of all, if I didn't manage to sell at end of trading, I would be able to sell for even less the next day untill 10am Greenwich Time.

You could say it is a shame I missed this trade, but this is completely beside the point. I have learned a lot by observing what my trade action would have been without putting money at stake. Next time a market price builds up that I am completely confident about its point moves, I hope I will have the guts to listen to my intuition and trade on it. Quite obviously it is conforting and true what Robert Petcher sais about this psychological problem all serrious traders epxerience at a certain point: It is difficult enough to develop a method that works. It then takes experience to believe what your trading method & intuition is telling you. But the thoughest task of all is turning analysis into money.