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 amount is reached.
A stop loss order can be used to cap the risk on a stock (or any asset) you purchased, or it can be used to cap the risk on any asset you sold short.
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. Some brokers don’t 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 next available price is based on the bid price, which is the next price which someone has posted an order to buy at.
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 is their stop loss.
The buy stop order triggers above the current price. The market order aspect will find any seller willing 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 and places a stop loss at $16. If there is a transaction 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 high volume 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.
Want to learn more about risk management and swing trading? My Complete Method Stock Swing Trading Course focuses on 4 patterns that tend to occur in strong stocks right before an explosive move.
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 limit order 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.
If you find order types confusing, here is an article on all the different order types for stocks.
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.
For 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. Following the 1% risk rule is also important for controlling risk.
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 staying in positions that keep losing more money.
Some brokers or exchanges only offer one of these order types. Quite often it is the stop limit order. If that is the case, give the order a wide margin between the trigger price and the limit price. This way you’re more likely to get out if the price moves against you.
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 our 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 out 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.
With a stop loss and selling 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. Trade long enough and you’ll learn this lesson the hard way.
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.
Holding onto losses is a trading mistake, and to become better traders we need to identify what our mistakes are and then work on improving them one by one.
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 the 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 close 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 (here are some ways to improve discipline).
For 95% of traders, I recommend you set your stop loss with a broker. Put the order out there. 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 Cup and Handle Strategy strategy, you will see one method I use to watch for consolidations near 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 like the MACD. 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. Layout exactly how you will trade your strategies in your trading plan—a document that details the researched and tested ways you will 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 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 action. 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.
If you like the idea of trading with ATR, check out the High Momentum Trend Trading Strategy which uses ATR for entries and exits.
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.
See How to Set Profit Targets for assessing the profit potential of a trade.
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 stop loss usage on stocks.
- 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 a broker or exchange only offers stop limit orders, use a big price difference between the orders to increase the chances of getting out.
- 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.
Want to learn more about risk management and swing trading? My Complete Method Stock Swing Trading Course focuses on 4 patterns that tend to occur in strong stocks right before an explosive move. It outlines when to trade, and when to stay away, and how to know the difference.
How do I determine position size based on my stop loss?
Determine how much of your account you are willing to risk. This can be a dollar amount, or 1% of the account in dollars. 1% of a $5,000 account is $50.
Then determine where the trade entry and stop loss are. Calculate the dollar difference between them. Entry at 5, stop loss at 4.75, is 0.25 difference.
Divide the risk amount on the account by the risk amount on the trade to get the position size. $50 / 0.25 = 200 shares.
See, How Much Stock to Buy for full details.
Won’t market makers hunt my stop loss order after I place it?
Yes, you are very important. With thousands of transactions going through the markets each second your single stop loss order will undoubtedly be a beacon for them to stop everything and take your specific money. But in all seriousness, losing trades will happen. Top traders typically lose half of their trades or more, because they want to be stopped out so they keep their losses small. Stop losses getting hit aren’t a conspiracy. They are just good risk management. If you find you are losing more trades than you want, adjust your strategy, but keep the stop loss order.
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.