Last Updated on 17 November, 2020 by Samuelsson
One of the most important decisions you can make to reduce your risk as a trader is to use a stop loss. By using a stop loss, you reduce the chances of finding yourself in a situation where losses quickly amass and make it impossible to continue your trading business. However, something that’s equally important is to determine how and when to take profit.
To set a stop loss and take profit in a proper way, you’ll have to consider the characteristics of the trading strategy. For instance, a mean reversion strategy will behave quite differently from a trend following strategy, which requires a somewhat different approach. This applies both to the stop loss distance and exit method that should be used!
In this guide, we’re going to discuss and show you the optimal stop loss placement for some of the most common types of trading strategies. We’re also going to look at how you should design your exits to extract as much profit as possible from the markets. The exit often is an overlooked aspect of a trading strategy, and in some strategies, it can even be a make or break factor.
The Role of the Stop Loss
Even though the basic function of any stop loss is to limit the amount risked on any trade, its role varies depending on the strategy you trade.
For example, some trading strategies may make use of the stop loss as the main exit mechanism. In those strategies, the stop plays an integral role, meaning that the strategy wouldn’t be tradable without it.
In other strategies, it will just be something that you lay on top of an already profitable trading strategy. In fact, it may even limit performance, as we’ll discover soon!
Now, in order to place a stop loss at the right distance, it’s important to recognize the role it plays in your particular trading strategy. With this in mind, let’s look at the role of the stop loss in mean reversion strategies and trend-following/breakout strategies.
The Role of the Stop Loss in Mean Reversion
Mean reversion strategies rely on the tendency of some markets to perform exaggerated moves both to the upside and downside, which are then corrected through a reversion to the mean.
As mean reversion traders, we try to define when the market has become overbought and oversold and enter in hopes of riding the corrective move that will bring the market back to equilibrium. In essence, it means that we’re trying to catch a falling knife, which in turn means that the following two points apply:
- The market is likely to continue down a bit after we enter a trade, before it finally reverts.
- We need an exit mechanism that doesn’t exit the trade before the reversion is complete.
We’re now going to discuss the first point and how you should go about finding the optimal stop loss placement.
Then we’ll jump straight to how you should go about to create exit methods that work well with mean reversion strategies.
The Impact of the Stop Loss on Mean Reversion Strategies
Since a mean reversion edge gets stronger the more oversold or overbought a market becomes, it means that any stop loss will exit the trade when the edge is at its strongest. And since mean reversion trades could continue down for quite some time after you have entered a trade, stop losses in mean reversion strategies must be placed at a fairly long distance away from the entry, not to have you stopped out all the time.
In other words, mean reversion strategies tend to work better the wider the stop.
This is the reason why we ourselves don’t use stop losses most of the time when trading mean reversion systems. However, in our case, this is possible because we trade many strategies at the same time through algorithmic trading. Thus the amount risked on each trade still remains fairly small.
How To Set a Stop Loss in Mean Reversion Strategies
As we mentioned earlier, mean reversion strategies work best without a stop loss. However, that’s simply not feasible for most traders since there must be some form of protection against outsize losses. Thus, we’ll have to figure out at what level it will make the least damage.
Here are two common techniques:
- Use a multiple of the average true range
- Place the stop loss slightly below or above a support or resistance level
1. Use a multiple of the average true range
Sometimes the best way to know where to place the stop is to use a multiple of the average true range of the market. As its name implies, the average true range(ATR) simply is an average of the recent bar ranges, and by using it to determine the placement of the stop loss, we get a dynamic stop distance that adapts to the current volatility level of the market.
Thus, the rationale behind using a dynamic stop loss level is that the distance the market is likely to move in the near future should be smaller in low volatility market conditions, than in high volatility market conditions.
However, it’s important to note that the short term volatility of a market may change quickly and without warning. This is why you need to make sure to use a quite long ATR – lookback setting of least 10 days, to get a more long term view of the market’s volatility.
The exact multiple you should use is up for you to decide. However, one common number that’s used fairly frequently is three. In other words, you should take the average true range reading, multiply it by three, and then subtract the number you get from the entry price, provided that you’re going long.
2. Place the Stop Slightly Beyond a Support or Resistance Level
Another approach that’s sometimes used by discretionary traders, is to identify strong support and resistance levels in the market and place the stop loss around those levels.
Now, those who go for this approach often stress the importance of not placing the stop exactly at the support or resistance level. The reason is that support and resistance act more like zones than exact levels. This means that a stop placed at the exact level of the support or resistance will put you at a much greater risk of getting stopped out of profitable trades, when the market will revert just a moment after having broken the support or resistance level.
In the image below you see how the market penetrated a support level, and then turned around just shortly thereafter. Also, note how the stop loss level was placed slightly under the support and made us avoid a too early exit.
Good Exit Methods for Mean Reversion Strategies
So having covered where to place your stop loss, let’s now move on to exit methods for mean reversion strategies.
Since a security may continue to fall for quite some time after an oversold signal, it’s important to use some sort of exit that identifies when the reversion to the mean is complete. Otherwise, you will find that you either exit before or after the reversion, and miss out on the profits that the trade had to offer.
In other words, you could say that you look to exit the market once it has gone from oversold to neutral, or even to overbought levels. Then it’s all a matter of using some technical indicator, such as the RSI, or some price action based condition, to define the overbought level, and use that as your main exit.
In the image below you see a classical mean reversion trade. We entered once the two-period RSI went below 10 and got out of the trade when it surged above 70, which showed that the market had reversed.
The Role of the Stop Loss in Trend Following
In trend following strategies, the stop loss plays a quite different role. Instead of severely limiting the profit potential like in mean reversion strategies, it acts more to limit losses and sometimes makes the strategy even more profitable.
This has to do with that trend-following strategies tend to have quite few winning trades. Sometimes the winning percentage could be as low as 20%, which is compensated by the fact that the average winning trade is much bigger than the average losing trade.
Thus, it becomes important to limit your losses and keep them small, so that the strategy remains profitable.
Still, it’s important to give the trade enough room to develop. Otherwise, you risk cutting out not only losing trades, but also winning trades!
How to Set a Stop Loss and Take Profit in Trend Following/Breakout trading
Having covered how to set a stop loss and take profit in mean reversion strategies, it’s time to look at how we would do the same when trading trend following or breakout strategies.
Most times you could apply the same types of stops as we did in mean reversion strategies, with the difference that the stop loss shouldn’t be as big in most cases. If you remember, this is partly because trend-following systems work by having a lot of small losses and a few big winners. In addition, a trend-following or breakout system works by going with the direction of the market, which means that we’re not trying to catch falling knives in the same way.
Considering the traits of the trend following approach, we might want to use some type of exit method that trails the price. This is where the trailing stop loss comes into play.
Trailing Stop Loss
The Trailing stop loss is practical in the sense that it not only acts as a stop loss, but also as the main exit method for some strategies.
A trailing stop loss, as it sounds, is a stop that is designed to protect profits by moving up or down with the market at a preset distance. For instance, you may use a moving average or price channels as a trailing stop to follow along with the trend as the market advances, and then get stopped out as soon as the trend reverses.
In the image below we see an example of a trailing stop that enabled us to follow the trend for quite sometime before it finally turned around, and crosses below the moving average.
Using Profit Targets With Stop Losses
Another approach that’s usually a better fit for trend following than mean reversion, is using a profit target in combination with a stop loss.
One important thing to remember here is to always have a good risk-to-reward-ratio. This means that you make sure that the stop loss is quite small compared to the profit target. One rule of thumb that’s often mentioned is to keep a ratio around at least 2:1, meaning that the profit target should be double as big as the stop loss.
How Big Should The Stop Loss Be?
Before we discuss how big a stop loss you should use, we must ensure that everybody is on track with what determines the actual stop loss size.
The size of your stop-loss is not only determined by the distance from the entry to the stop loss level, but also by your position size. In short, if you trade 200 stocks instead of 100 stocks, you will be risking double the amount with the same stop loss distance.
In general, you should decide the placement of the stop loss first and then decide your position size. Otherwise, you run the risk of placing the stop too tight to accommodate a larger position size, which may cut off too many winning trades.
How much is a reasonable stop size then?
A reasonable stop loss size is no more than a few percent of your total account balance. A common figure is 2-3% at most, and we would agree that it’s a good guideline to follow.
The danger of risking more is that you quickly will find yourself in drawdowns that become very hard to get out of. For example, if you decide to risk 10% on each trade, you would only need 5 consecutive losers to have a 50% drawdown. Such a drawdown would require a massive return of 100% only to be back at breakeven.
Instead, if you instead were risking 2% of your capital on every trade, you would be in a modest 10% drawdown which is much easier to recover from!
Types of Stop Loss Orders
As you have seen, the stop loss and its placement is a very important factor for a trading strategy to be able to perform at its best. And while everything in this guide applies to a normal stop-loss order, you might benefit from knowing about the other types of stop-loss orders that exist, and how they work.
Now, if you’re only going to use a normal stop-loss, there is no need to know about the differences between the following two order types. However, if you want some more control over the price at which you’ll exit the market, you should have a look at them.
The examples below will use sell stop orders only. If you’re shorting a market, you’ll be using buy stop orders to cover your position. The same rules, but inverse apply to those presented below, apply to those order types.
Sell Stop Order
The sell stop order is a normal stop loss order, which means that a market order to sell the specified number of securities will be issued as soon as the market falls to the stop price or lower.
While a stop order will get you out of the market as soon as it goes below the stop price, it doesn’t guarantee that you get out on the stop price. For instance, if the market gaps below your stop level, you’ll still get out of the trade, but at the current market price which will be lower than the specified stop level.
Another scenario is that the stop level is hit in highly volatile market conditions and that the market order will incur a lot of slippage. In that case, you might also get a bigger loss than your set stop loss amount. Especially if you’re trading illiquid markets where slippage is more common!
Now, there is another stop loss type that tries to solve these issues…
Stop Limit Orders
A stop limit order combines a limit order with a stop order to give you more control over the final execution price. In short, you could say that it lets you decide the worst price you’re willing to accept once the stop loss level is hit.
Here is how it works:
- When the stop level is hit, a limit order will be sent to the market to buy at the limit price, which is set in advance, or higher.
- Now the position will be closed only if the market trades at the limit price or higher.
The main difference to a normal stop-loss order is that a stop-limit order will send out a limit order rather than a market order once the stop level is hit. And since limit orders will only be executed at the limit price or better, you’ll not get out of the trade if the market trades lower than the limit level.
The image below illustrates a stop-limit order where the limit level is placed below the stop level.
Now, while it might be tempting to use this order type in your trading, keep in mind that using it comes at the expense of not knowing if you’ll get out of the trade or not, if the market drops below the limit price!
In this article, we’ve had a closer look at how you could go about to set a stop loss and take profit in trading. We’ve shared some common techniques that usually work well with the trading strategy types that have been discussed.
Still, you need to keep in mind that every trading strategy is different and will react differently to various exit and stop-loss techniques. Therefore you need to make sure to use backtesting to validate your ideas, not to impose rules that make significant harm to your trading strategies!