How to Use Trading Stop-Loss Orders
When trading, you use a stop-loss order to overcome the unreliability of indicators, as well as your own emotional response to losses. A stop-loss order is an order you give your broker to exit a trade if it goes against you by some amount. For a buyer, the stop-loss order is a sell order. For a seller, it’s a buy order.
Enter your stop-loss order at the same time you enter the position. In fact, you need to know the stop in order to calculate how big a position to take in the first place, if you’re using any risk-management rule.
Technical traders have developed many stop-loss principles. Each concept is either a fixed trading rule or a self-adjusting one. Stops relate to indicators, money, or time, and often these three don’t line up neatly to give you an easy decision. You have to choose the type of stop that works best for you.
The 2 percent stop rule
The 2 percent rule states that you should stop a loss when it reaches 2 percent of starting equity. The 2 percent rule is an example of a money stop, which names the amount of money you’re willing to lose in a single trade.
Risk-reward money stops
The risk-reward ratio puts the amount of expected gain in direct relationship to the amount of expected loss. The higher the risk-reward ratio, the more desirable the trade. Say, for example, that you’re buying Blue Widget stock at $5 and your indicators tell you that the potential gain is $10, which means that the stock could go to $15. You could set your initial stop at $2.50, or 50 percent of your capital stake, for the chance to make $10. That gives you a risk-reward ratio of 10:2.5, or 4:1. (Strangely, the amount of the gain, the reward, is always placed first in the ratio, even though it comes second in the name.)
Maximum adverse excursion
John Sweeney developed the concept of maximum adverse excursion, which is the statistically determined worst-case loss that may occur during the course of your trade. Using this method, you calculate the biggest change in the high-low range over a fixed period (say 30 days) that’s equivalent to your usual holding period. Actually, you need to calculate the maximum range from the entry levels you would’ve used. Because you know your entry rules, you can backtest to find the maximum range that was prevalent at each entry.
Trailing stops use a dynamic process that follows the price: You raise the stop as the trade makes profits. A trailing stop is set on a money basis — you maintain the loss you can tolerate at a constant dollar amount or percentage basis. You could, for example, say that you want to keep 20 percent of each day’s gain, so every day you’d raise the stop day to include 80 percent of the day’s gain.
This method means calling the broker or reentering the stop electronically every day. The important point is to keep the stop updated to protect gains and guard against losses at the same time.
Indicator-based stops depend on the price action and the indicators you use to capture it. Indicator stops can be either fixed or self-adjusting. Here are some important ones:
Last-three-days rule: The most basic of stop-loss rules is to exit the position if the price surpasses the lowest low (or highest high if you’re going short) of the preceding three days.
Pattern stops: Pattern stops relate directly to market sentiment and. For example, the break of a support or resistance line is a powerful stop level, chiefly because so many other traders are drawing the same lines.
Moving-average stop: You can also use a separate indicator that isn’t part of your buy/sell repertoire to set a stop, such as a moving average.
Volatility stops are the most complex of the indicator-based, self-adjusting stops to figure out and to apply, but they’re also the most in tune with market action:
Parabolic stop-and-reverse model: Create an indicator that rises by a factor of the average true range while new highs are being recorded so that the indicator accelerates as ever-higher highs are met and decelerates as less-high highs come in. In an uptrend, the indicator is plotted just below the price line. It diverges from the price line in a hot rally, and converges to the price line as the rally loses speed.
Average true-range stop: This stop is set just beyond the maximum normal range limits. You take the average daily high-low range of the price bars, adjusted for gaps, and expand it by adding on a constant, like 25 percent of the range.
Chandelier exit: This stop solves the entry-level issue. Invented by Chuck LeBeau, the chandelier exit sets the stop at a level below the highest high or the highest close since your entry. You set the level as a function of the average true range. The logic is that you’re willing to lose only one range worth (or two or three) from the best price that occurred since you put on the trade.
Time stops acknowledge that money tied up in a trade that’s going nowhere can be put to better use in a different trade. Say you’re holding a position that starts going sideways. It is reasonable to exit the trade and find a different security that is moving.
Clock and calendar stops
Clock and calendar stops pertain to a price event happening (or not happening) based on the time of day, week, month, or year. Clock-based rules abound. Some technical traders advise against trading during the first hour in the U.S. stock market because buy- or sell-on-open orders are being executed then. Others say that more gain can be had from the first hour than any other hour of the trading day if you can figure out which way the crowd is trading.