A stop loss is a crucial element in controlling risk on a stock trade. The term is used to describe an order that gets you out of a trade once a pre-determined price or loss is reached.
A stop loss order can be used to cap the risk on a stock (or any asset) you purchase, or it can be used to cap the risk on any asset you shorted.
Stop Loss Order Parameters
A stop loss on a long position (one you bought) is actually a “sell stop market” order when placing a stop loss through your broker. Most brokers don’t actually have a “stop loss” button. You need to set the parameters for it via a “sell stop” order type.
A sell stop order is one that triggers below the current price. A market order is one that will take any buyer it can find to sell your shares to, no matter the price, once the trigger price of the stop order has been reached. A sell stop market order is a combination of the two.
For example, let’s say you buy a stock at $10, and want to get out—to control your loss—if it drops to $9. Place a sell stop market order at $9. This is your stop loss. If the price drifts lower and a transaction occurs at $9 or below, your sell order is triggered.
Maybe there is still a buyer at $9 to sell to, or maybe the next buyer is at $8.95. In either case, your order will be triggered at $9 and will take the next price available to get out.
The same concept applies to a short position [shorting is selling first, hoping to buy the shares back at a lower price, because you expect the share price to fall]. Since a trader is short, they will place a buy stop market order to exit their position. This their stop loss.
The buy stop order triggers above the current price. The market order aspect will find any seller willing to sell to fulfill your buy order, at any price, once the buy stop price has been triggered.
For example, you decide to short sell a stock at $15.75 but want to place a stop loss at $16. If the price moves up to and transactions at $16 or above, the buy stop is triggered.
Since it is a market order it will find anyone it can buy from once $16 has been hit. In a liquid stock (lots of participants and shares changing hands) that will likely mean the order will fill at $16 or maybe $16.01 or $16.02.
In both cases, the stop loss has gotten a trader out of a losing position.
Stop Loss Limit Order
It is also possible to set a stop limit order, instead of a stop market order. The market order will take any price to close out the position once the stop price is triggered.
A limit order will only fill within a certain price area.
Let’s go back to the long position example. We bought at $10 and placed a stop loss at $9. This time we use a sell stop limit order with a trigger price of $9 and a limit of $8.95.
This means that the order will trigger at $9, but will only sell down to $8.95. If the available price to sell at is below $8.95 the order won’t sell your position until the price is back at or above $8.95.
Assume the stock had an earnings announcement overnight and the stock went from $9.25 yesterday and opens at $8.50 today. Even though you had a stop loss on the position, you will still be in that trade. Why? Because the next available price below $9 is $8.50, in this case, which is below the $8.95 limit on the order.
Stop Loss Limit Order or Stop Loss Market Order?
Both the stop loss limit order and market order have pros and cons. The downside of the market order is that you get the price you get, whether you like it or not. In the case above, you sell your shares at the next available price: $8.50, even though you wanted out at $9. You lost an extra $0.50, and that loss is now locked in. You are out of the position.
With a limit order the same thing happens. You are still losing $0.50 more, per share, than you wanted, but you are still in the position. While the price could rally and get you out at $8.95 or above, the price could also drop even more, resulting in an even bigger loss.
To professional traders, controlling risk is key… which is more important than hoping a trade will turn around so you get out at a smaller loss amount.
Therefore, opt to use a stop market order. Yes, occasionally we will end up getting a price we don’t like. But not using a stop market order opens the door to remaining in positions that just keep losing more and more money.
Why Use Stop Loss Orders?
Determining your stop loss makes sure that you have actually considered your risk. While we all want our trades to be profitable, for most people, only about 50% (maybe 60%, maybe 40% or less) of our swing trades or day trades will be profitable–and that’s with using a good explosive swing trading strategy. Even winning 40% of trades is more than enough to make a lot of money. I’ll discuss that a bit later in the Risk/Reward section.
So if a good chunk of trades, even for the pros, aren’t going to work out, we want to cap how much we lose on those losing trades.
Not having a stop loss means potentially sitting on losses that grow. You wanted to get when the stock fell 5% from your entry point, but you didn’t have a stop loss order and now the stock is down 10% and still falling. If you didn’t sell it at a 5% loss are you going to want to sell it at a 10% loss? Probably not, and then before you know it you’re down 30%. Still holding it.
Not only is the position losing more than you originally planned, but you have also tied up capital that isn’t being used to make money. Say you put $15,000 into that position that is now losing 30%. Yes, you are down $4,500, but you have also given the opportunity to use that money elsewhere.
Had you had a stop loss and sold at the 5% loss, your loss would be must smaller—$750 instead of $4,500—and you would have $14,250 of available capital to buy something else that could hopefully make back your loss plus much more. The longer you hold a loss the more opportunities you are giving up!
There is the argument—used by many traders on their way to going broke— that if you hold onto something you will be able to get out at a better price.
Nope. Price can move against you a long way and for a long time. Tying up your capital for weeks, months, or years instead of taking a loss early means you not only face unknown and potentially catastrophic risk, but you eliminate your ability to make any money from other opportunities with that capital.
If you place a stop loss and the price bounces back, who cares. If it presents a good opportunity, get back in. But always, always, set a level to get out at before a trade, and then stick to it. Don’t waste time or money hoping a losing trade will bounce back. Take the loss, and go make money on something else.
Should You Place Your Place Loss with the Broker or Just Manually Exit at the Trigger Price?
This is an important question, and to be honest, you will find great traders on both sides of fence. Some insist on placing a stop loss, and having that order placed so that if the trigger price is reached you get out of that position right away.
The benefit is that you know you are getting out. The downside is that your stop may be triggered and then you watch in horror as the price goes right back in the direction you expected.
Other traders will argue that you should monitor the price and see how the price is acting around the stop loss area. Possibly wait for a price bar to cloe below the stop loss price (if long) for example, and then exit.
The benefit is that you may be able to avoid losing your position on a short-term “blip” in the price. The downside is that you have to monitor prices constantly, and most people don’t have the skill to determine in real-time if a price move is a “blip” or whether they really should get out. So as the price approaches their stop loss they tend to give it a bit more room, hoping it will turn around, then a bit more room, then a bit more. Also, the onus is really on the trader to pull the trigger on getting out. Lots of traders lack that discipline.
For 95% of traders, I would recommend you set your stop loss with a broker. Get out, and then get back in if the price starts moving better again, or move onto another opportunity. Also, this means you don’t need to watch your trades all day.
Where to Place a Stop Loss
The most basic answer is that your strategy should tell you where to place your stop loss or when to get out of a trade.
My strategies all revolve around similar occurrences, so that makes it easy to determine where my stop loss will go.
If you check out the Continuation Patterns strategy, you will see one method I use to watch for consolidations near an important areas. I then wait for a breakout (in the expected direction) of that consolation and then place a stop loss on the other side of the consolidation.
Consolidations are when the price moves in a small range, mostly sideways, for several price bars.
You could also place a stop loss at a point where the idea for the trade is no longer valid. For example, if you are trading a bullish (expect it to go up) candlestick pattern and the price drops below the low of the pattern you should get out. You expected the price to go up, it didn’t, so there is no reason to stay in the trade. Staying in a trade after your idea failed is gambling. Now you are just hoping it goes up.
Same with a technical indicator. If you get a buy signal, determine the point on the chart where you can say “Nope, that didn’t work.” That’s your exit point. If your trade idea goes against you, pre-determine where you will know it isn’t working.
DETERMINE THE EXIT POINT BEFORE TAKING THE TRADE.
Let’s go back to my consolidation breakout stop loss, as hopefully that will help you determine where to place a stop loss for your own strategies.
The stock below was in a rising trend channel. The price consolidated near the bottom of the channel and rose above the high of that consolidation. When that occurred is marked by a circle.
Charts from TradingView.
The stop loss, in this case, would go below the low of the consolidation. We are buying when the price rallies above the consolidation high, expecting the price to go up. If it drops below the consolidation low, what we expected didn’t happen. Get out.
I will place my stop loss about 0.1% below the consolidation low for most stocks.
That’s how I trade. You can always add a bit more of a buffer if you like. Or you may opt to not use a buffer at all (put the stop loss at the consolidation low or even above the consolidation low).
Here’s another example, based on the Cup and Handle strategy.
Stop Loss Based on Volatility
You could also set a stop loss based on the asset’s volatility. For example, the Average True Range (ATR) is a common indicator used in this way. The ATR shows how much, on average, the stock moves each price bar. Some traders opt to have a stop loss at 2 x ATR. So if a $50 stock has an ATR of $0.40, your stop loss is $0.80. If the ATR is $3, the stop loss is $6 away from the entry point.
Look at your entry points on historical charts to see if this method would have worked for you. Adjust as needed. You may find 1 x ATR is enough room if you have very good entry points.
Even if you use indicators for entry signals, set a price-based stop loss. If an indicator provides a buy signal, place a stop loss below the recent swing low. If an indicator provides a short sale signal, place a stop loss above the recent swing high in price.
As discussed prior, you can include a small buffer of room below the swing low if you like, or place a stop loss at 2 x ATR (or whatever multiplier you decide on) below your entry price in this case.
The point is that you need to control risk based on price. Price is where your profits and losses are, so don’t base the stop loss on anything but price.
If you wait for an indicator to trigger you out at a loss, you may end up losing way too much as indicators can be slow to react to real-time price changes.
Your Stop Loss Helps You Assess Your Risk Versus Your Reward
Before any trade, I make an assessment of whether my potential return is greater than my risk. In order to do that, I first need to know what my risk is. If I don’t know that, then there is no way to determine what a good trade is.
If I think a stock will go up 20%, that seems pretty good. But If I am willing to lose, or end up losing, 20%, 30%, or 40% because I don’t have a stop loss in place, now that 20% profit doesn’t seem as good.
You may say “I would never lose 40%”…and that’s good. You can keep that promise by using a stop loss and sticking with it.
If I cap my risk, at say 5%, and I expect to make 20%, my potential reward is 4x my risk. When your potential profit is larger than your risk, it means you can win less than 50% of your trades and still make money. And if you win more than 50% of your trades, that’s just a bonus!
Stock Stop Losses – Tying it all Together
Here are my summary recommendations for stock stop loss usage.
- Use a stop loss, always.
- Once you decide on the stop loss level, actually place the stop loss order with your broker. That way, you know the order is there to be executed when the price is reached, and you don’t need to worry about the loss getting bigger or not having the discipline to get out.
- I use stop market orders. I want to get out, now, if my stop trigger price is hit.
- If I take a long trade, I place a stop loss just below the consolidation or whatever pattern triggered my trade.
- On a short trade, I place the stop loss just above the consolidation or pattern that triggered my trade.
- If you didn’t use a price pattern for your entry, then place the stop loss at the point where your idea is proven wrong.
- Determine your stop loss level BEFORE you enter the trade. Place your stop loss at the same time as your trade, or immediately after.
To see how the stop loss is incorporated into a complete swing trading strategy, check out the totally free Stock Swing Trading Mini Course.
By Cory Mitchell, CMT
Disclaimer: Nothing in this article is personal investment advice, or advice to buy or sell anything. Trading is risky and can result in substantial losses, even more than deposited if using leverage.