A Guide To Stop Losses

“Whenever I enter a position I have a predetermined stop. That’s the only way I can sleep at night. I know where I’m getting out before I get in.”- Bruce Kovner

 The biggest reasons traders end up unprofitable is simply because their big losses knock out all their previous gains.

If you went back and removed your biggest losses over the past few months or year what would your trading results look like? Many of the best traders I know did this at some point in their trading careers and had an enlightening moment. The major factors that made them unprofitable or caused them big draw downs in capital were the big losses. The roots of the big losses were usually based in emotions and ego not a market event. A big loss is almost always caused by being on the wrong of a trend and then staying there.

What are the top 10 root causes of big losses in trading?

1. Too stubborn to exit when proven wrong: You just refuse to take a loss; you think a loss is not real as long as you do not exit the trade and lock in the paper losses.
2. Too much ego to take a loss: You are on the wrong side of the market trend but think if you hold a losing position you can be proven right on a reversal. While you are waiting to be proven right your loss gets bigger and bigger.
3. Too much hope for a reversal: You think the market just can’t keep moving against you and must reverse at current price levels.
4. Trading too big a position size: The bigger you trade the bigger your potential loss and the more likely that your emotions will override your trading plan.
5. Buying in a downtrend: Bulls in bear markets lose money as markets make lower highs and lower lows.
6. Selling short in an uptrend: Bears in bull markets lose money as the market makes higher highs and higher lows.
7. No trading plan: When you don’t have a plan for your trades you plan to fail. You don’t have an exit plan on entry so when faced with losses you don’t know what to do.
8. No trading system: If you do not have a quantified and proven price action trading system then your trades are just random in nature. Big losses will happen due to the random nature of entries and exits.
9. Bad position sizing parameters: Big losses will occur when position sizing is not based on historical volatility and worst case scenarios happen.
10. No discipline: No self control to create a systematic trading process and even if there is one, then no discipline to follow a predetermined method.

What is the solution to all of these big losses? A very simple one in principle: a stop loss. A stop loss is meant to do exactly what it says, stop your loss. A stop loss sets the predetermined risk for your trade in monetary terms. You know at what price level you are getting out when you get in. A stop loss is your quantified price risk level that will tell you that you’re wrong if your trade goes that far against you.

The first step in figuring out your stop loss level in a trade is to quantify “If this trade is going to work out for me then price should not go to this specific price level, if it does I am proven wrong and will need to exit.” A stop loss has to be given enough room for you to not be shaken out prematurely with normal price action but at the actual level that is meaningfully against you and shows something has changed from your initial entry.

There are many ways to quantify a stop loss on a trade at entry:

• One of the most popular stop losses is at a level of long term price support for a long position or a price level of resistance for a short trade. These are the key places that swing traders place their stop losses as they believe a break out of a range changes the market from range bound to trending and their trade could continue to trend against them.
• Moving averages are another place that stop losses are placed. The moving average would depend on the timeframe of the trade.
• Moving average crossovers are another option for a systematic place to exit a loss. There are mechanical trading systems where you simply enter a trend trade when a shorter moving average crosses over a longer one and then exit when the shorter term moving average crosses back under the longer one.
• Use a ‘stale’ or ‘time’ stop: Set a time limit on how long you will give a trade to move a certain amount, if it fails to move enough fast enough, get out. If you are not making money you are both tying up money in a flat trade giving you opportunity cost and also carrying the risk of a loss if the trade moves against you. The fact the trade is not moving in your favor increases the odds that it won’t but will instead move against you.
• Volatility stop: Stop out if the market or your stock has a big expansion in its daily price range, or starts moving against you the full daily range. You either cut your position down in size, or get out due to increased risk based on volatility expansion. The ATR (Average True Range) is a one way to quantify this.
• Sell your position because you have found a much better trade with a better probability of success, or a bigger upside. Depending on your available capital there are times you will want to simply exit a losing trade for a better opportunity even if your stop loss has not been hit.
• Stop losses can be taken instantly intra-day, end of day, the next morning, end of week, or end of the month. This depends on the timeframe you are trading on.
• Stop losses can be automated with your broker or taken manually.
• A trailing stop is not the same as a stop loss. A stop loss is the way you exit a losing trade to avoid a big loss. A trailing stop is how you exit a winning trade by raising your stop behind your winning trade. When it reverses and hits that trailing stop, you sell. A trailing stop can be a short tem moving average or a percentage of your open profit. A trailing stop is how you lock in profits on a winning trade while they are still there.

Managing stop losses is a key skill that has to be developed for profitable trading. A stop losses’ job is to keep losses small but it must be set in a place that allows enough room for a winning trade to also play out without getting stopped out prematurely.