Setting a stop-loss correctly
A stop-loss limits your loss but doesn't guarantee a price. It belongs at the point where your thesis is proven wrong, not at whatever amount you wish for.
The stop-loss is the level where you admit you were wrong. Once it's hit, you sell, without having to decide in that moment. That's exactly where its value lies.
The most common mistake is setting it too tight. Prices fluctuate even for no reason. A stop placed in the middle of normal noise gets triggered even though nothing happened, and the price often then moves in the expected direction anyway.
The second-biggest mistake is moving it once it's reached. Do that, and you don't have a stop anymore, you have a hope. Moving it lower is always wrong. Trailing it higher as things go well, on the other hand, makes sense.
Important to know: a stop doesn't guarantee a price. If the price gaps overnight, the sale executes at the next available price, which can be considerably lower. The stop limits the usual case, not the exceptional one.
Placement should follow market structure. A common approach derives it from a volatility measure, such as a multiple of the average true trading range, so the stop sits outside normal fluctuation. Alternatively, a notable price level serves as the reference, one whose breach would invalidate the original thesis.
A fixed relationship exists between stop distance and position size. Set the stop farther away, and share count must fall proportionally to keep risk constant. The common approach of picking the share count first and then setting the stop tight enough to match the loss you want reverses this relationship and systematically produces premature stop-outs.
Worth noting is the visibility of clustered stop levels. Prominent price levels attract stop orders, whose triggering in turn amplifies short-term moves. Placing a stop exactly on a round number or just below an obvious price level therefore raises the odds of getting caught in a brief overshoot, without the underlying situation having actually changed.
Summary
- The stop belongs where your thesis is proven wrong.
- A wider stop necessarily means a smaller position.
- A stop limits the usual case, not a price gap.
Did you get it?
What happens with an overnight price gap?
The stop executes at the next available price, which can be considerably worse.
What follows from a wider stop distance?
A proportionally smaller position, to keep risk the same.
Why are round numbers a bad choice for a stop level?
Because stop orders cluster there, and brief overshoots catch them.
Related
- Order typesStage 1
- Your first orderStage 1
- Spread, slippage, and liquidityStage 1