Limit your risk with stop-loss orders
Summary: Learning how to manage risk is essential for any trader or investor. By using stop-loss orders, you're able to limit losses on securities that make unfavorable moves for no extra cost - on both long and short positions.
What is a stop-loss order?
A stop-loss order is an order to sell or buy a security, such as a stock, once it reaches a certain price. The purpose of a stop-loss order is to limit a trader's loss on a security position. For instance, setting a stop-loss order at 5% below the price at which you bought the stock will limit your potential loss to 5%.
More specifically, suppose you just purchased the Facebook stock at $100 per share. Just after buying the stock, you set a stop-loss order at 5% ($95). If the stock reaches $95, the stop-loss order gets activated and you’re selling the stock at $95, equaling a loss of 5% ($5).
What are the advantages of setting a stop-loss?
The main benefit of a stop-loss order is that you’re able to limit your downside on both long and short positions for no extra cost than the regular commission charged when the trade is executed.
In addition, stop-loss orders allow decision-making to be free from any emotional influences. Traders tend to "fall in love" with certain securities. For instance, they may have the false belief that if a stock is given another chance, it will come around, which instead may cause losses to rise.
Find the optimal stop-loss level: different stop-loss strategies
While there are numerous methods of identifying the right stop-loss level, there’s not one that suits all trading strategies. Instead, you should go through a few and consider the one that suits your trading framework and risk appetite the best.
One of the most popular stop-loss methods is the 2% rule, which means never putting more than 2% of your equity at risk. If you trade with $50,000 for example, using a 2% stop loss means you could risk up to $1,000 on any given trade. Although the 2% rule is popular, you can choose any level that’s comfortable for you, such as 1%.
Learn more about the 2%-rule here.
The Average True Range
The ATR is considered as the most accurate volatility indicator. As opposed to other volatility oscillators, it paints the true picture by capturing the entire price range of an asset and factoring gaps into its calculation.
One way to use the ATR is to identify your stop-loss level, and a common strategy is to set your stop-loss one ATR from your entry position. For instance, if you sell 20,000 EURUSD at 1.0958 and the ATR-14 is 198 pips, you would set the stop-loss at 1.1156. If you’re a more conservative trader, you may want to set your stop-loss at 2x or 3x the ATR from your entry point.
Another strategy is to set your stop-loss one ATR from the nearest support or resistance level. By doing this you give the trade room to breathe and lower the risk of getting closed out from volatility spikes through your resistance or support level.
Learn more about using the Average True Range indicator for setting stops here.