Where to Place Your Stop-Loss Order?
Tired of frequent stop-outs? Where should you place your stop-loss order for effective risk management in trading?
In this article, we’ll be looking at managing risk per trade in more detail, and if you haven’t read my previous articles on this topic, please do. This will be a direct follow-up on the subject.
Where do you put them if you’ve decided you’ll be using stop-loss orders to protect your trading capital? What options do you have? How else can you manage risk if you don’t want to use stops?
Listen, I get it. I wouldn’t say I like using stop-losses, either. I hate it every time the market swings lower to take me out and then continue in accordance with my original plan. It happens all the time, no matter what I do regarding placing stop-loss orders. One has to make peace with that fact. Your stops will be taken out, and a small percentage of your capital will be gifted to the market Gods.
Call it a tax on trading or an insurance policy protecting you from severe draw-downs. Most people spend money every year on insurance for their car, house, and health to protect what they value most from taking on too much financial damage. This is no different.
A safety tax for making sure that no matter what happens in the markets, you’ll survive to fight (trade) another day.
As annoying as getting stopped out is, it pales compared to the pain of a significant draw-down, especially if you should have known better and chose to remove the stop to save a few bucks but ended up with a giant hole in your portfolio.
Never remove your stop once you’ve set up the trade. Just don’t. It’s not worth it. Yes, you might get away with it and save some money for a while, but your time will come sooner or later.
The market will do what the market does best - surprise the hell out of you in the most violent way possible and take your money.
Optimal stop-loss placement
The placement of your stop order can be optimized, depending on your chosen strategy. But I must disappoint you; there is no “one cure for all” solution here.
You must monitor and journal your trading and note where the price likes to hunt for stops and where your stops usually survive. Since I don’t know your trading strategy, I will mention a few ideas and clues to look for in your trading.
Stop hunts
There is a joke meme that you should put your stop where you usually enter your trades. It’s just a joke, but there is some truth to it.
Take a stroll through your favorite charts and observe the behavior of the price. Then look for all the places you would typically place your entry plus stop, and see what would have happened.
Would the stop survive spikes, volatility, and anomalies?
Is it, perhaps more often than not, that the price first does the exact opposite of the predicted move before actually making that bounce of support, breakout, or fake-out, whatever it is that you are looking for?
In my trading, the price “hunting for stops” or simply “faking moves” is the norm, not the exception. That’s why I’ve based most of my trading upon that fact.
I rarely trade breakouts unless they are exceptionally strong and backed by other factors (time, accumulation, volume, news…). I mostly expect that all breakouts (on either side of the support/resistance/pattern levels) are nothing more than stop hunts and fade them.
Sometimes I go guns blazing and hunt for offset entries, where all the breakout traders would be salivating over future profits and fade them. At other times I wait to see the reaction, and if my suspicion is confirmed, I enter the trade back within the lines. You can see some ideas for easier illustration in the following charts.
Text-book stop placement
Now if you’re trading a support level, for instance, you would generally enter the long position a little above the support line and place your stop somewhere below the support line.
Unfortunately, that is expected in the market, and the market likes to play liquidity games at these levels.
That is why you will see a lot of these levels broken either by a spike lower or an actual fake breakdown that gets retracted. If you’re placing your stops below the support line, you’re then just asking to get taken out. Do you see my point?
The same can be said of most other technical signals. They tend to fake or fail in the first couple of attempts, so even if you’ve got the direction of the move right, chances are you’ll get stopped out or confused by the price action.
This is especially true in ranging/flat market conditions. There’s a range being established, and on both sides of the range, you will see such spikes/fake-outs/stop hunts quite often.
In trending environments, these cases are usually more one-sided than not. Since the trend is so strong, the winning side tends to get in before our support/resistance lines are ever touched, and the losing side tends to take a bit of a hit, giving some territory to the invaders, before managing to fight back the stronger market forces. Observe these patterns within the scope of your trading strategies and adapt your entries, exits and stop loss placement.
Without complicating things too much, let’s make this simple.
Trend matters
In a strong bull trend, support often gets front-run, and price action tends to break higher through resistance, at least for a while. In a bear market, the opposite is usually the case.
Notice the use of the word usually, not always! It’s all just a game of probability. Remember that!
So where do you put your stop for it to be safe?
As far away as possible from the expected price action would be the most logical conclusion, would it not?
But there is a problem with that. If you move your stop loss far away from your entry, you are taking on more risk if you end up being wrong and get taken out. You lose more money.
So then, you have to lower your position size to stay within your predetermined risk tolerances (how much money you’re willing to lose on this trade). And that tends to hurt your potential profits if you’re right and the trade ends up winning. It also heavily impacts the overall profitability expectancy over a large sample of trades because your win rate may increase, but your win-to-risk ratio goes down the drain.
Trading is a fine art of balancing the probability of winning and risk/reward ratios.
One way to combat this problem is by altering where you enter the trade. So instead of entering the above support in our example, you enter where your stop would typically be. Remember the joke?
Most trading strategies you pick up from the manuals have designated stop loss placement spots, places where it is assumed that the trading idea is invalidated. Nothing against those, but since they are usually widely known and monitored ideas, the market forces tend to play mind games with them and hunt for stops in those usual places.
Another is always to expect these sorts of fake movements and exaggeration in the market and try to:
Either catch them as they happen - set up a trap (2)“just in case optimistic order,” or
Wait for the price to do its thing and see if it returns to your predicted move, entering upon confirmation as it’s called (3).
The second will raise your win rate but lower the number of plays you get. There is always a price to pay, friend. It’s wise to back-test different approaches on a large enough sample size and then play with the variables. Whichever one produces the best overall result is the winner. At least, technically.
You should get to know your exchange well. You see, even in placing your stop loss orders, you will find many options. Not only limit vs. market (do yourself a favor and stick to market), but you can also choose between different data points for the order to be triggered. Those can be the last price, index price, or mark price. Choose the one that fits best with your strategy.
Don’t neglect the mental side of things.
Some can stand to sit on our hands and not get any trades for a long time; others cannot. Some can take a lot of losses all the time and not blink an eyelid; others end up under their blankets after a few failed attempts. Know yourself and adapt your strategies accordingly!
There is no point in having the best trading strategy if you cannot mentally execute it perfectly and keep at it through some inevitable adversity!
As I’ve mentioned, there is no one perfect way to place your stops, and you can never avoid being stopped out unnecessarily. It will happen from time to time. Your only choices are the following.
WIDE STOPS
Choose to set your stops very wide, thereby raising your win rate but severely hurting your risk-to-reward ratio. This will work best if you’re trading with large sizes and don’t aim for high-profit margins in percentages. It is also applicable if you are an investor or generally hold your trades for more extended periods.
TIGHT STOPS
Opt for very tight stops, thereby taking on more losses, but as your stops are tight, you aren’t taking much damage, so you can afford to. Having tight stops also gives you better risk-to-reward ratios on your trades. This means that when you win, you win big. This will probably be the way to go if you are a day trader or trade smaller sizes. If you can handle the emotional impact of having a lower win rate and taking more losses, that is.
The most important point is to never allow your losses to grow large.
Keep them small in any way you know how to. If your system is solid and you have an actual EDGE in the market, your winners will ultimately take care of the losers. You will have to endure losses, so you had better make friends with them!
The other option every trader continuously works on is to improve your trading system, striving to achieve more winners, maximize profits and minimize losses, improve your entries and exits, compound, add confirmation to your trading, etc.
Even when you believe that you have found the perfect trading system, entries and stop placement, the market will change. The markets always change.
Be especially observant of price volatility, liquidity, volume, and behavior untypical of your market. What works today doesn’t have to work tomorrow. It is up to you to continuously adapt to the market. There will also be times when your trading strategy simply will not work. You’ll know that’s the case when you can’t win, no matter what you do. Those are the times to back away and take some time off.
Trading is not a job; you can’t make money all the time.
If you’re a position trader or more of an investor, perhaps basing your trading decisions on factors unconnected to the charts, like news, fundamentals, general market conditions, insider information, or gut feeling…, this advice won’t do you much good. If your entry and thesis aren’t based on the chart, your stop cannot be either. Logical, right? What can you do, then, to protect your capital?
In another article, we’ll look at other ways to guard your hard-earned money, so be sure to subscribe.
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