Generally, where do you add a stop loss? When I think about this, one of two choices come to mind:
1. Add a stop loss at a key price level, based on TA. Let's say I enter XYZ on the 200 day SMA bounce. I would add a stop loss a few cents (.05-.10) below the SMA. By the way, is there a rule to determine how many cents below the SMA I should add the stop loss?
2. Add a stop loss based on a fixed percentage. For example I enter XYZ at $100 and I set my stop loss at 2% of my entry price, which would be a $98 stop.
Personally, I think adding a stop loss based on TA at a key price level is much "smarter" than adding a stop loss based on an arbitrary percentage. For example, let's say I were to enter XYZ at $100 and assume it's consolidating between $95 and $105. If I were to add a 2% stop loss, I would be stopped out at $98 for a loss if XYZ were to plunge. However, let's say there was a 50 day SMA right below the $95 level, such as $94.90. If I were to add a stop loss at $94.80 and XYZ were to bounce off of the SMA, I wouldn't be stopped out and could wait for XYZ to touch $105 for a profit.
Which option is the better choice? Or is there something else that I'm missing entirely? Keep in mind that I only study TA as of now.
Where to add a stop loss?
This is what you would have seen on May 18th. You look at the chart and tell yourself that the 525 level is significant because traders have made decisions when price touched that level in the past. You decide to enter long on the first sign of weakness of downward trend (which would have been on May 18th, the indecision candle). So here is where you're question comes in. If I simply do a 6% stop loss, it completely ignores the framework of the price movement. But if I think a little bit, it would make more sense to put the stop loss where my entry prediction was proved wrong. So if that 525 level does not hold, my edge is gone. The prediction was wrong and the stop loss kicks in (somewhere around 510).
Profit said: ↑
Generally, where do you add a stop loss? When I think about this, one of two choices come to mind:
1. Add a stop loss at a key price level, based on TA. Let's say I enter XYZ on the 200 day SMA bounce. I would add a stop loss a few cents (.05-.10) below the SMA. By the way, is there a rule to determine how many cents below the SMA I should add the stop loss?
2. Add a stop loss based on a fixed percentage. For example I enter XYZ at $100 and I set my stop loss at 2% of my entry price, which would be a $98 stop.
Personally, I think adding a stop loss based on TA at a key price level is much "smarter" than adding a stop loss based on an arbitrary percentage. For example, let's say I were to enter XYZ at $100 and assume it's consolidating between $95 and $105. If I were to add a 2% stop loss, I would be stopped out at $98 for a loss if XYZ were to plunge. However, let's say there was a 50 day SMA right below the $95 level, such as $94.90. If I were to add a stop loss at $94.80 and XYZ were to bounce off of the SMA, I wouldn't be stopped out and could wait for XYZ to touch $105 for a profit.
Which option is the better choice? Or is there something else that I'm missing entirely? Keep in mind that I only study TA as of now.
Click to expand...
The key to placing your initial stop loss is to place it where your pattern is broken. I would hold to this regardless of the kind of trader you are, so whether you're a day trader, a swing trader, a position trader, or an investor, you're more likely to also be a pattern trader (with very long term investors as a possible exception). Even if you trade channels, reversals, or simple trend continuation patters, there is some underlying pattern you're looking for in your setup.
Let's take a first simple retrace going long on a stock as an example. Once you have your initial impulse move to the upside followed by a smooth retracement back, you will find that if you have your cycle indicators properly set, you should be able to pretty accurately identify high probability cycle lows, and even if you find yourself caught up in a complex retrace that later confirms that what you thought was your cyce low wasn't, there is very high probability that your next cycle low is an a, b, c complex retrace (which are awesome to trade, I might add), assuming that you're in an established trend with at least some strength to the momentum with a confirmation on the higher time frame and no cluster of resistance overhead on your setup chart.
So, where is your stop placed? Exactly one tick below what you think is the cycle low. For example, if you believe the cycle low is exactly $8.56, then it's my firm belief that you should place your stop at exactly $8.55. Give it absolutely no room (well, no more than a single tick) to move below the cycle low. Remember, the cycle low is the lowest low in price between the previous and next cycle high, and if you're expecting an impulse move upwards in price after you've analyzed other usual and usually necessary elements in your trading methodology, then you would have absolutely no business being in the trade if what you thought was the cycle low wasn't the cycle low--at least that's the way it is with my trading methodology.
Doodman and fast, thanks for the detailed responses.
I had a very similar thought process to Doodman's and I feel more confident now that it's confirmed. It just didn't make sense to add a stop loss based on a set percentage while ignoring price action. It almost feels ignorant to just ignore the chart right in front of your face and place an arbitrary stop loss. Your post definitely helps.
Fast, your reasoning makes good sense and has given me insight to think about the exact price to add a stop loss- especially the last sentence. I'll give this thought when adding stop losses from now on. The example took a few tries to follow (relatively new to trading), but I think I got it. Much appreciated.
Thanks to both of you, I have a much better understanding now.
I'll agree with the other responses that it is better to us TA and set a stop below support rather than use some arbitrary percentage loss. However, rather than "one tick below" as suggested above, I prefer to look at closing prices. Too often I have seen the price test an obvious support level by going below it to scare out those stops, and then close above the support. Yes you might lose a few pennies by holding on till the close, but I would rather wait till near the closing bell to see what really is happening with that day's price action.
A corollary of this discussion is that once you know where your stop is going to be, you know how much money you will lose if you get stopped out. This tells you how many shares to buy. For example, if you know you are going to lose 5 points if the price falls below the support level, and the most you are willing to lose is $500, then you know your maximum investment in this stock would be 100 shares.
John
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The problem with fixed percentage stops is there is no real reason for placing the stop where you do.
For example, suppose you buy some stock, and declare that you will have a 5% stop. But what if there is strong support at 7%. I would place the stop at 8% to let the 7% stop hold. You would stop out at 5%, and miss the stock when it bounces off of support at 7%.
If an 8% stop exposes you to too much loss, reduce your trading size until you are comfortable with the 8% loss.
John
My new book is now available on Amazon. It teaches you my favorite trade for beginners. The pros use the same trade every day. Or, if you'd like a free quick summary of what's in the book, you can get it here.
Check out Stock Market Insurance Trader at
http://bit.ly/SMITbooka.
“Everything you need to know is laid out plain as day in a simple to understand way. It’s so simple it’s BRILLIANT!”
“Highly recommend this text for someone who is new to options.”
“Simple to read, understand and apply.”
I'll echo the sentiments of others that I never understood fixed-percentage stop losses. I look at stop-losses the same way I look at entry points and profit targets - for all three, I want to have a reason for my choice. A stop-loss is the price at which the price action of the stock has confirmed your initial hypothesis incorrect, and it won't be the same in every trade. Some trades may be based off of a particular support level, so logically a stop immediately below that support level makes sense.
Other stops may be based on particular quotes in the Level 2, thus a stop-loss based on some order further on in the order book may make sense. Generally, your stop-loss should be theoretically coherent with your entry rationale. They shouldn't be based on two completely different ideas.