A stop loss order can prevent significant losses for an active trader
The market decides how much money you make trading; you decide how much you lose. At least that’s what the professional traders I know tell me. So how do they decide how much money they are willing to lose on a given investment? A stop loss order.
In fact, they tell me that a stop loss order is absolutely critical for two reasons. First, and most important, they limit your potential loss. Think of a stop loss order as capping your loss on a given trade. And second, they take your emotions out of the equation when it comes to exiting a trade that didn’t go as you expected.
So let’s look at what a stop loss is, how to execute one with your broker, and why they are so important.
What is a Stop Loss
A stop loss is an order placed with your broker to sell a security if it reaches a certain price. For example, you buy stock XYZ at 50 and tell your broker to sell if it drops 10% to 45.
There are three types of stop losses orders:
A hard stop loss is an order placed with your broker to exit a trade upon reaching a certain price. The price that will trigger the sale is fixed and doesn’t change as the price of the stock moves up and down.
A trailing stop loss is based on a percentage or dollar spread relative to the current price. For example, you could place a trailing stop loss order that automatically sells the stock if it falls by 20% or $10. With this type of order, the price that will trigger a sale changes each day as the price of the stock moves up and down. This type of stop loss is sometimes referred to as a percentage stop loss.
A soft stop (or mental stop) is not placed with your broker. It is merely a price you determine in advance where you should exit a trade. The problem with soft stops, as you might imagine, is you can (and most likely will in the heat of the moment) change your mind. Your natural instinct to avoid losses will lead to paralysis, which will give way to rationalizing why you took the wrong course of action and held on to the stock.
How to Execute a Stop Loss
Placing a stop loss is simple. The actual process is different with each broker so you will need to familiarize yourself with the trading platform. With Scottrade, for example, placing a stop loss order takes just seconds and a few clicks of the mouse:
Notice the two drop down boxes that I’ve circled. With the first one, I’ve selected a trailing stop. When selected, the second circled drop down box appears allowing the trader to select a percentage or dollar trailing stop. Add the ticker symbol and the stop loss amount, and you’re done. If you need further help, call or email your broker. If they can’t help you, get another broker.
Since stop losses held with your broker are market orders (unless you specify a limit price), the price you receive after the stop loss is triggered may be different than your stop price. This may happen during fast moving markets and/or if your stock is illiquid. The only way to prevent this is to use a limit order which specifies which price you are willing to sell. If the price drops below your limit price and never recovers, however, you will never sell the stock (and may watch it fall much further.)
How to Use a Stop Loss to Limit Losses
Anyone fighting the relentless uptrend in gold last fall knows the importance of using a stop loss. For example, you might have shorted (bet the price would drop) gold at the end of July 2012 around 1175 because gold was in a downtrend. If you didn’t use a stop loss you would have been wiped out as gold quickly rebounded and rose more than 250 points over the next three months. A good trader would have placed a stop loss (for example 5%) and only lost 58.75 instead of 250.
Stops should account for volatility – or how much a stock moves. For example, a biotech needs a larger stop than a utility because a volatile stock could easily trigger a stop loss as part of its normal movement.
One of the best ways to systematically determine the size of a stop is to use the average true range (ATR) developed by Welles Wilder. The ATR measures the average daily stock movement over a defined time period. For example, the ATR for the last 14 days for Apple (AAPL) is 14.10. This means AAPL moved 14.10 over a 14 day period. Most trading platforms calculate this for you automatically.
As an example, let’s assume you want to buy 3 D Systems (DDD) because you believe the uptrend will continue. Where should you place the stop? It should be more than 1 ATR below your entry price because the stock could drop that much without jeopardizing the uptrend. If it drops more than 1 ATR, however, you could assume the uptrend is over (at least for now) and should exit the trade immediately. So you place the stop 2 ATR below your entry price.
A real world example
A stop loss prevented a good friend of mine from losing even more money on a recent trade. He was once a day trader, but today I’d describe him more as a swing trader. Here’s his story:
On 11/27/12 I shorted the NASDAQ 100 (QQQ) due to resistance at the 200 day moving average and previous support around $65 from the end of October. I set a stop loss of 0.87 which was based on the 10 day ATR. Although QQQ gapped down slightly the next day, my profit target was much farther away and didn’t trigger. Price quickly recovered by the end of the day and triggered the stop loss several days later on 12/3/12.
QQQ spent the next month trading in a sideways pattern. Even if the price had eventually hit my profit target I’m glad I exercised discipline and took the loss. It’s tempting to focus on the time you should have held on to a losing position that would have worked out and not about the time you let go of a losing position that didn’t. Remember, it only takes losing your discipline once to end your trading career.
Downside to stop loss
The risk to using a stop loss is that you buy a stock, get stopped out at the bottom (called “bottom ticking”) then watch it rebound and hit your original profit target. This is every trader’s second worst nightmare. Remember, the worst nightmare of buying a stock and watching it go to zero can be prevented by using a stop loss):
Although many traders experience losing trades on a regular basis and accept it as a cost of doing business (what business doesn’t have costs?), the psychological trauma can be too much to bear for newer traders. The “flash crash” in May 2010 is a prime example. In this instance, stop losses were triggered and the stock recovered all on the same day. Since the trading activity was considered an aberration and not “real selling”, however, it provided fodder for skeptics to say stop losses should never be used. They use the most extreme example to talk you out of doing something that will protect you the vast majority of times.