Setting a stop-loss correctly
A stop loss limits your loss, but it doesn't guarantee a particular price. It belongs at the point where your reason for buying no longer holds, not where your preferred amount lies.
Learning objective: After this lesson you can place a stop loss at a well founded point instead of at your preferred amount.
The stop loss is the mark where you admit you were wrong. When it's reached, the position is sold without you having to decide in that moment. That's its whole value, because people rarely decide well in that moment.
Stops set too tight
The most common mistake is setting it too tight. Prices wobble back and forth a bit even without a reason. If your stop sits in the middle of that normal noise, it gets triggered although nothing happened, and afterwards the price often runs exactly in the direction you expected.
Moving the stop
The second most common mistake is moving it when the price gets close. Then you no longer have a stop, only hope. Moving it down is always wrong. Moving it up when things go well, on the other hand, makes sense.
No price guarantee
Important: a stop doesn't guarantee a price. If the price jumps down overnight, the position is sold at the next available price, and that can be much lower. The stop protects you in the normal case, not in the exceptional one.
An example trade with made up numbers
Tom buys a stock at €40. The last clear low is at €37.80, and on a normal day the stock swings by about €0.90. He wants to lose at most €100 per trade.
Version A, stop at a preferred amount: Tom buys 100 shares and sets the stop at €39.00, because that makes exactly a €100 loss. The next day the stock briefly drops to €38.80, then rises to €44. The stop was hit, Tom is out with a €100 loss and €6 in costs, and watches the rise from the sidelines.
Version B, stop in the right place: Tom sets the stop below the low, at €37.50. Because he now risks €2.50 per share, he buys only 40 shares for €1,600. The brief drop to €38.80 doesn't touch the stop. At €44 he sells and is €160 ahead. After €2 in fees and about €1.60 in spread, roughly €156 is left.
If the stock had fallen below €37.50, Tom would have lost €100 plus costs, as planned. The stop in the sensible place forced him to buy less. That's the price for not being thrown out by normal swings all the time.
Where the stop belongs follows from the chart. Many use a measure of the usual fluctuation, such as a multiple of the average daily range, the ATR. That puts the stop outside the normal back and forth. Others use a prominent point on the chart. If the price falls below it, the original idea no longer holds.
Distance and position size
The stop distance and the position size are firmly linked. An example: Sara wants to risk €150 at most. The share is at €50, the ATR is €1.50, and she sets the stop two ATR away at €47. Then she may buy 50 shares. Had she put the stop at €49, she could buy 150 shares, but would be stopped out for no reason much more often. Many do it the other way round. They pick the number of shares first and then set the stop so tight that the loss fits. That gets them stopped out too early all the time.
Clustered stops
Also bear in mind that stops cluster in certain places. Many stops sit at round numbers or just below an obvious low. When they're triggered, that briefly amplifies the move. If your stop is exactly there, a short overshoot catches you although nothing has changed. A few cents away from the round number often helps.
A stop-loss, step by step
Summary
- The stop belongs where your idea is proven wrong.
- A wider stop always means a smaller position.
- A stop protects in the normal case, not in a price gap.
Did you get it?
What happens with an overnight price gap?
The stop is filled at the next available price, which can be much worse.
What follows from a wider stop distance?
A correspondingly smaller position, so the risk stays the same.
Why are round numbers poor places for a stop?
Because many stops cluster there and short overshoots trigger them too.
Check your understanding
Your task
You want to buy a stock at $25. Based on your reasoning, the stop loss belongs at $23.50, and you want to lose at most $90. Use the position size calculator or work it out by hand to find how many shares you may buy and what your purchase amount is.
Sources and further reading
- Research by Carol Osler (Federal Reserve Bank of New York) shows that stop-loss orders cluster at prominent price levels such as round numbers, and that their triggering can produce self-reinforcing price moves and cascades. View source ↗
Related
- Order typesStage 2
- Calculating position sizeStage 3
- Spread, slippage, and liquidityStage 2
- Matching questions for this stageQuestions