Properly Setting a Stop Loss Order
A stop loss order (also known as a stop order or just a stop) is used to exit a trade if it starts to lose (i.e., if the market moves against the trade). This is one of many tools that traders can use to add some downside protection to their portfolio.
Like all types of orders, there are advantages and disadvantages. For a stop order, it will be executed as a market order once the price of the stock reaches the stop order amount. At this point, execution is guaranteed but not at a specific price. There is a common belief that a stop order “protects” the stock from being sold below it. A stop limit order provides this protection by executing a limit order but sacrifices guaranteed execution.
Stop loss orders are used as normal exits and as emergency exits (i.e., stop the collapse), but the following suggestions are based on using a stop loss order as a normal exit.
How to Properly Set a Stop Loss Order
There are two different ways to properly set stop loss orders. One method is more suitable for discretionary traders, while the other method is more suitable for systematic traders. Therefore, the method you use to set stop loss orders should be based on the type of trader you are. If you don’t yet know what type of trader you are, please determine that first.
The discretionary trading method is to set a stop loss order at a price that you do not expect the market to trade at. In other words, you will set a stop loss order at a price that, if traded, would change your opinion about the direction of the market. The idea behind this method of placing a stop loss order is that if the market reaches your stop loss price, you will not want to remain in the trade, so the stop order will exit the trade on your behalf.
The systematic trading method is to set a stop loss order based on the risk-to-reward ratio and the win-to-loss ratio in your trading system. In other words, if the risk-to-reward ratio and the win-to-loss ratio in your trading system indicate that the optimal distance for a stop loss is 10 points behind the entry price, then the stop loss order should be set 10 points behind the entry price. This method relies on mathematical calculations, and there is no subjective estimation in the decision of where to place the stop loss order.
There is an alternative version of the systematic trading method for placing a stop loss order using indicators. If you have determined during the testing of your trading system that a certain indicator pattern provides an optimal trade exit, then the stop loss order should be placed based on the indicator pattern rather than the risk-to-reward ratio and the win-to-loss ratio.
How to Incorrectly Set a Stop Loss Order
There are many ways to incorrectly set a stop loss order (and traders are likely inventing new ways every day), however, there are more common methods than others.
Percentage-based stop loss orders are orders that are placed at a fixed percentage behind the entry price. For example, if a long trade is entered at 1250, a stop loss order set at 2% would be at 1225 (25 points lower than the entry price). The percentage used may be based on the entry price, the value of the trade (i.e., price times the number of shares), or the trade target. Regardless of the calculation used, percentage-based stop loss orders are not based on market dynamics in any way, so it is not surprising that they are not an effective way to set stop loss orders.
Stop Orders
Stop-loss orders at arbitrary prices are orders placed at arbitrary prices. Arbitrary stop-loss orders are used in an attempt to place stop-loss orders at less obvious prices. However, humans are ineffective at choosing random numbers, so these supposed random numbers are not random at all (like a trader who always chooses round numbers without realizing it). Similar to orders based on percentages, arbitrary stop-loss orders are not based on market dynamics. Additionally, arbitrary stop-loss orders cannot be tested, so there is no way to know if they are placed at a profitable price or not.
How to Place Your Stop-Loss Orders
If you are a discretionary trader, you should consider the reason behind placing a stop-loss order at a certain price, and if you do not know the reason, it is not a good stop. Discretionary stop-loss orders should be based on market dynamics; otherwise, they will not be effective in protecting your trading capital (which is the goal of a stop-loss order).
If you are a systematic trader, you should have testing results that precisely determine where your stop-loss orders should be placed, and then follow the results exactly. If you have testing results, or if you do not follow the results, you are adding unnecessary risks to your trading, which is the opposite of what a stop-loss should do.
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Source: https://www.thebalancemoney.com/how-to-place-stop-loss-orders-1031091
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