Stop loss Strategies for Market Traders

In all forms of long-term investing and short-term trading, deciding the appropriate time to exit a position is just as important as, if not more important than, determining the best time to enter into your position. Getting into the market is the easiest part of trading, exiting with a profit is the skill that all traders are striving to master.

The other aspect that makes the use of stop loss strategies difficult is emotion. When we first get involved in the financial markets, many of us are thinking purely on the upside - the thought of losses is only vaguely considered. Add to this the emotion of greed and often you have a recipe for disaster. Stop loss strategies are vital to both the short and long term trader as they provide a road map to follow, ensuring emotion can be left on the sideline. Knowing this, it is surprising how many market participants do not trade with stop loss strategies.

There is a common argument that arises when I talk to people in the market about these strategies, it is the fear that by exiting the market with your strategy you are potentially giving up extra profit. This is true, however, this is greed talking. We want to identify an optimal point to exit, which ensures acceptable profits, while guarding against unacceptable losses. This is the theme of a stop loss strategy, minimising losses and maximising profits. It is important to note that it is not a perfect system, however, it’s the best strategy we have.

The first thing to consider in stop loss strategies is time frames. An investor who trades for the long term will have far different stop loss strategies than a day trader trading off a 1 minute bar chart. An investor will have a larger range of price movement allowable within their stop whereby a day trader may exit at a movement of a few cents against them.
To start very simply the most basic of stop loss strategies is a time stop. That is setting a period of time that you will be in the trade for e.g. 1 day, 1 week etc. This strategy will be very broad in its results but as you can see it is the easiest to understand.

Most stop loss strategies deal with price action, simply you can look to exit at even dollar amounts. This style is popular with long term investors as psychologically we see round dollar amounts in a positive light. That is if we enter at $9.20 we may look to exit when the market trades at $10. Once again this is fairly vague in its approach when compared to some of the more technical ways we can place our exit prices.

The most popular style is a trailing stop that is to calculate your exit at a percentage of your capital say 10%. If the market price were to fall (in the case of a long trade) by 10% from your entry point on the same day then you would exit. The trailing stop is progressively moved in the direction of the trade each day ensuring as the market rises you are locking in profit. The hardest part of this strategy is calculating what percentage you should use, 10% may be very acceptable to some whereas to others this would expose them to far too much risk. Once again this method can rely a little on the emotion of the trader and their overall risk profile.

At the end of the day there are no right or wrong answers for the stop loss strategies. The only mistake we can make is to trade without them. To begin with, establish the time frame that you will trade on, and then decide on what style of stop loss you will implement, time, price or indicator - they all have merit. Once you have established what road you want to head down you will need to back test this against the markets you are looking to trade to maximise its benefits. Once you have this information you will then have a very strong road map to follow and a great tool at minimising the emotion that can be a hurdle to success in trading.

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