Strategies for Setting Stop-Loss Orders

In response to two recent emails from readers asking about approaches to setting stop-loss orders today I am going to cover off a couple of different strategies often used by traders when deciding where abouts to set their stop loss. I’m guessing the recent market reversal (the DOW is down over 600 pts in the last week and a bit) may have led to a fair few people getting stopped out of long positions and has left many wondering if they set their stop correctly, should they have had it tighter, perhaps allowed a bit more room for movement, maybe considered moving it so as not to get stopped out…

Nobody wants to ever see their stop get triggered, especially when the market (as it loves to do) reverses sharply, after minutes after hitting your stop to leave you nursing a nasty loss on your trade. But losing trades are part and parcel of spread trading, you are never going to call every trade correctly. So that’s way it is important that you plan for trades going against you by putting in place a stop-loss order that gives your trade time to work while still limiting your losses to an acceptable level should it go wrong. Here are some approaches to consider when setting your stop-loss.

Adopt a Tight Stop but be Prepared for Regular Stop-outs

Ok, first up we have the approach of putting a very tight stop in place. When adopting this approach what you are basically doing is hoping you have called a bottom or a turn in the stock. You are going to put a stop in place just under the most recent level of established support, often based on a short term timeframe (10 or 30 mins). With this type of trade you should be looking for any of the following before opening the trade:

• A significant reversal on large volume, increasing the likelihood that you have caught the bottom.
• A bounce off previous support (if going long) or resistance (if going short). See last weeks Dollar Tree example.
• Stock is very close to a moving average or trend line that has acted as support of resistance in the past.

In each of these scenarios you will be putting your stop as close as possible to the key decision point which in turn keeps any potential losses, should the trade not hold up as expected, to a minimum.

Traders who go with these types of tight stops tend to have many losing trades (often a lot more than the number of winning trades they have) but each loss is only a very small fraction of their trading portfolio. When the trades go as planned they often result in significant winning returns and thus provide the trader with an excellent risk / reward ratio. E.g. Having a stop-loss set at a level where the risk is maybe only €100 but the their target profit is 5 times that.

A Loose Stop Gives Your Trade Time to Work

The opposite approach can also be taken where you apply a much looser stop-loss, thus giving your trade more room and time to work in your favour. In today’s volatile markets where 100 point swings are not uncommon this strategy can often pay-off. Many traders refer to “noise” in the market and how you should discount this and focus on the overall trend when making your trading decisions. Putting wide or loose stops in place helps off-set the risk of market noise leading to your position getting stopped out despite the fact that in the longer run you called it right. Have a look at the Morgan Stanley chart since the start of the year below. The trend has certainly been up but not without plenty of volatility and short-term pullbacks along the way. A loose stop here would have paid off where as a tight stop would have seen you stopped out of the trade very quickly.

The downsides of this approach to setting your stops are fairly obvious:

1. If you are stopped out you are going to be hit for a bigger loss than in the first approach we discussed above. And those bigger losses are going to be a bigger percentage of your trading portfolio, meaning you’ll be able to sustain less trades going against you over time.
2. Your risk / reward ratio on these types of trades is not going to be great. You could be getting into trades where you are risking a €300 loss for perhaps a targeted profit of €400, a little over 1 to 1 which is not what we typically look for.

A Percentage Stop Can Lack Flexibility

Another approach often used is to set your stop based on a percentage of your portfolio you are willing to risk on each trade, let’s say 3% of your portfolio. So if you had a €10K trading account you would risk no more than €300 on any trade and you would set your stop-loss accordingly. A variation on this approach is to set your stop-loss based on a percentage of the current price of the stock, currency or commodity you are trading. So lets say you are trading Microsoft at $20.00 want to go short. You decide to deploy a stop 10% above the current price, so you put your stop at $22.00. If the stock hits that well it is 10% off where you traded so it is pretty clear you called the trade wrong and it’s time to get out.

While I like the idea of quantifying your potential loss as a percentage of your overall portfolio (it’s good to know if you are risking 2, 5 or potentially 10% of your portfolio on a single trade…it might make you think twice about putting it on), having such a rigid approach to setting your stop-loss mean you don’t get the flexibility you need when choosing where to put your stop. It could result in you putting too wide a stop in place or not a large enough one in other cases. Likewise while knowing the percentage a stock needs to move to hit your stop is very useful (e.g. are we talking a mere 1% move and you are out…not a lot of room for error there), again using a set rule of X% from the current price to set you stop may not give you the flexibility you need. Also, because you will most likely be trading stocks of various prices and volatility, a 10% move can mean vastly different amounts of risk, e.g. A 10% move on a €1 a tick trade on Microsoft at 2000 would see you risk a max of €200, however the same 10% move on a €1 a tick trade on Apple trading at 14000 would see you risking €1,400!

Using Gaps to Set Your Stop

One less common approach to setting your stop is specific to stocks that either gap significantly lower or higher on a given day. These scenarios don’t happen that often but when they do it’s worth adopting a strategy specific to them if you are going to join the action. Stocks that gap significantly tend to do one of two things, either fill (close) the gap or carry on moving in the direction of the gap. If you think the latter is more likely and decide to open a trade on a stock that has gapped, then the logical place to put you stock is just below the gap up or above the gap down as the case may be. The RIMM chart below is a classic example of such a trade. Back at the start of April the Blackberry maker gapped up significantly (over 20%) on the open after they announced results that blew the market away after the market close the previous day. From there the stock rallied another 50% to peak at $85 a share last week. The thing to notice is that if you went long on the gap up you could have put a stop just below the day’s low and stayed in that trade for a long time, resulting in a very successful trade. In this example the gap held. Of course in many cases gaps like these are filled because that’s what the market likes to do. In such a scenario you would have had your stop perfectly placed to limit your loss as far as possible.

No Stop-Loss is Not A Strategy

I’m not going to dwell on this one as I don’t really consider it a viable trading strategy but I am aware of traders who have tried to adopt this ‘strategy’ so I thought I’d throw it in for completeness… The idea behind not setting a stop-loss is that well you can never get stopped out and therefore can wait as long as it takes for your trade to be proven right (unless of course you were long Anglo and it suddenly got Nationalised!). I’ve mentioned many times in various posts that becoming a successful spread trader is all about managing your risk, keeping your losses to a minimum and letting your winners run. I’ve also spoken about knowing when you are wrong, never catching a falling knife, risk / reward ratios, etc, etc..Not having a stop-loss in place on a trade goes completely against all of these well known trading rules. No one can make you use a stop-loss but if you don’t you are asking for trouble.

Some Final Thoughts On Stop-Losses

Whatever strategy you decide to adopt when it comes to setting your stop-loss, be it one of the above or some other approach I believe you should always set some sort of stop-loss. As mentioned above it’s not a good feeling when your stop-loss is triggered but trust me, more often than not it is for the better. Yes there will be the nasty reversals which serve to multiply the pain of the loss you have just taken but if you have set your stop loss at a particular level for a particular reason you are better off accepting the loss if the stock ends up reaching that level. Moving your stop order is very tempting, and can on occasion pay off (just like averaging down works the odd time too) but in most cases moving your stop order means one thing and one thing only, accepting a bigger loss. It may take a few hrs longer, a few days or even a week or more, but moving your stop-loss generally only puts off the inevitable.

Here’s an example from close to home…I got stopped out of a long position on Yahoo trade myself late last week. Yahoo was in what I considered to be a nice trading range for over two weeks, moving between 1610 and 1670. It had also received a number of analyst upgrades with price targets of $20 plus on the back of an improved online advertising market and a new CEO who has impressed so far. So when it came back down towards 1620 two weeks ago I decided to go long for €5 a tick, putting my stop 50 pts below (risking €250 on the trade). I considered going even tighter with my stop, just under 1600 but decided to give a little more room for movement plus at 1570 I was just below the gap up on 1st June. After an initial rise back up towards 1650 the stock price started to reverse and soon I was in negative territory. Three days after opening my trade I was stopped out at 1570 as planned (well not really but you know what I mean!). 2 days later it jumped up 3% and I was going ‘Oh here we go…back up to 1670 within a few days I bet…should have moved my stop…’. However if I now look back at the price action since then my stop-loss was a blessing in disguise. As you will see from the chart below the very next trading day (Monday of this week) Yahoo fell almost 7% (about 100 pts), followed by another 20 point drop at one point yesterday to hit 1450, that’s 120 pts (€600 at 5 a tick) below my stop that was only hit last week. While I was disappointed with how the trade went I’m happy enough with the approach I took, both from an entry point and from a stop-loss setting point of view.

All trades are different and you should set your stop-loss based on the particular set-up you are considering but hopefully the approaches discussed above will give you some options to consider.