Last Updated on 17 November, 2020 by Samuelsson
In order to become a long term successful trader, it is paramount that you control your risk. Many are those who start their trading career with far too large positions, and end up losing all their capital.
One of the most effective ways to control risk is to use a stop loss. With a stop loss, you always know what you are risking on each trade, and using this knowledge you can adjust your position size so that you never risk too much!
A stop loss is an order that liquidates all positions in a trade when the maximum allowed loss in that position is reached. The stop loss level needs to be set with the market type and characteristics in mind. For example, a volatile market will require a wider stop loss, and vice versa.
In this complete guide to stop losses, we will look at what a stop loss is and how you should use one. And in addition to that we will cover:
- How to know how much you should risk
- Different types of stop losses
- The different stop loss order types
We have a lot of material to cover, but before we begin, it could be good to demonstrate why controlling risk and using a stop loss is so important!
The Importance of Having a Stop Loss
Imagine that you have a trading strategy that historically has had a losing streak of 10 trades. This is completely normal, and it is very likely that you will experience an even longer streak in the future!
The strategy exits a trade only when it hits the stop loss, or once it hits a profit target. In other words, a losing trade always means that your stop loss is hit.
Now, let’s say that we have three traders who set up their stop loss differently.
Trader 1 sets his stop loss to 2% of his initial account balance
Trader 2 sets the stop loss to 6%
And trader 3 decides to go all the way up to 10%
Now assume that we get 10 consecutive losing trades as in the backtest. This is what happens to the above traders:
Trader 1 experiences a 20% drawdown.
Trader 2 is down 60%
Trader 3 is completely wiped out
Out of these three, trader 1 was the only one who came out unscathed. While trader 2 had enough capital to continue trading, his capital was decimated and it would take a quite substantial return of 150% to be back at breakeven!
One of the hardest things in trading is to strike a balance between risk and return. If you risk too much you are soon wiped out. On the other hand, if you risk too little your returns will suffer!
You always need to be aware of the risks, and carefully choose where to put your stops.
You will sometimes hear about traders who claim to make returns of several hundred percents a year. In many cases, this is a result of excessive risk taking! If you were to come back to the same trader a few years later, most would have lost their capital. Reckless position sizing magnifies returns. but also put you at risk of losing it all!
What Affects the Stop Loss Amount?
As you probably have understood, using a stop loss in your trading is vital to reduce risk and ensure that you are in the game to profit not only today, but also tomorrow.
Later in the article, we will cover quite a few different ways of calculating where to put the stop loss. However, now I thought that we would have a closer look at the parameters that affect your risk level, and subsequently decide how much you risk in a trade.
These are the three factors that you need to consider and play with when it comes to stop losses:
- The distance to the stop loss
- Your position size
- Are you trading on margin?
Distance to Stop
The distance to the stop loss quite obviously determines how much you risk. If the stop loss is placed farther away from the entry, the amount you could lose increases as well. For some types of trading strategies like mean reversion strategies, you will find that you need a quite large stop loss. We will touch on stop losses and mean reversion strategies later on in the article!
In order to ensure that you do not risk too much even with a large distance to the stop loss, you will have to position size accordingly. For example, let’s say that you are in this situation.
- You want to risk a maximum of $1000 on each trade
- You enter a trade in a stock that is priced at $100. You set your stop loss at $80, which means that you are risking $20 per share.
In order to risk no more than $1000 on this trade, you will have to do the following calculation to know how many shares you can buy:
Allowed Risk/Risk per share = number of shares to buy
If we put the figures from the example into the calculation above, it shows that we can buy 50 shares and still not risk more than $1000.
In general, you should not risk more than 2% of your capital on every trade. In other words, if you want to risk $1000 on each trade, you should begin with a capital of no less than $50000.
Calculating the Stop Loss Amount when Trading on Margin
There are several ways you can trade on margin in the market. The two most common are to either trade a contract that has inbuilt leverage like futures, or buy stocks on margin by lending money from the broker.
Calculating the stop loss for margin contracts like futures is a little different from how you do it with stocks. This has to do with that these contracts have inbuilt leverage, which creates the need for first knowing the value of each point and tick in the market.
One tick is the smallest increment in which a security can move, and several ticks make up one point. For example, the S&P500 e-mini futures contract has a tick value of $12,5 and one point is made up of 4 ticks. Thus, the point value is $50.
Now, in case we were to buy this very contract at 1340.00 and set the stop loss at 1320.00 we would have a distance of 20 points from the entry to the stop loss. Knowing that one point is worth $50, we are risking $50*20=$1000.
Stocks on Margin
When using leverage, that means that you are adding extra weight to your position beyond your own invested capital. In order to calculate how much you risk, you need to know how large your position as a whole. This typically is no different to when you trade without margin. Just take the distance to the stop loss calculated by the number of stocks you buy, including those that were bought on margin!
How to Calculate How Much to Risk – Position Sizing
Before we go into the different types of stop losses, we will have a look at a few different ways to determine how much you are willing to risk on every trade.
What is important to point out is that this calculation preferably should not impact where you place the stop loss on the chart. Instead, it should guide you in how many shares or contracts you buy on that very trade.
This has to do with the fact that the placement of the stop loss can have a huge impact on the performance of the strategy. For example, if the stop loss is placed too tight, you will get stopped out all the time before you have given the market a chance to develop in your direction.
Here we cover a few ways you can decide how much to risk on every trade. If you are new to trading we recommend that you focus on the first two only, since they are simple and tend to work very well!
1. Fixed Dollar Amount
The fixed dollar stop loss is the most simple of all methods and is widely used among traders. You just choose a dollar amount that you are willing to lose, which preferable is no more than 2% of your account value.
For example, if you have an account balance of $100 000, and want to risk no more than 2% on each trade, your allowed risk becomes $2000.
2. Fixed Percentage Amount
The fixed percentage amount is another very simple, yet powerful method. Instead of choosing a dollar amount, you set your risk as a percentage of your current capital. This method could be quite similar to the fixed dollar approach, since the latter often also often is derived as a percentage of the total capital.
However, as we choose to define it, the fixed percentage method has one major difference. That is that the dollar amount you may risk constantly changes with the fluctuations of your trading capital. For example, when the account is down 20%, the percentage share of the account you risk will also be 20% smaller, and the other way around. With the dollar approach, we keep the dollar amount constant and don’t adjust for capital depreciation during the drawdown.
This trait of the fixed percentage approach, has two major consequences:
- It allows for constant compounding, since the dollar amount available to risk increases with the portfolio, gradually letting you increase the position size.
- It lowers the risk of going bankrupt, since the dollar amount risked also decreases with a shrinking portfolio. In other words, it resembles the anti-martingale approach, which is covered soon.
Both of these might seem very positive at first, but they do not come without issues.
One of the major concerns we have with it is the idea that you should decrease your position size as you move into a drawdown. Since we are very careful with how much we risk, we know that there will be an end to our drawdown eventually. As such, we want to take full advantage of the recovery, and be fully invested in that phase. That will not be the case with a fixed percentage approach, since we have constantly lowered the dollar amount at risk as we sank into the drawdown.
The Kelly Criterion is a somewhat more advanced position sizing formula that outputs the percentage of your capital that should be used in a trade. Unlike the previous two methods, the kelly criterion also takes into account the characteristics of the trading strategy.
Here is the formula:
In order to make use of the Kelly formula, you must have a backtested and validated trading strategy.
If you want to learn more about backtesting, have a look at our guide to algorithmic trading, where we show you how you should backtest a strategy.
The martingale approach to position sizing is one of the most dangerous methods you could employ. Despite that, using martingale in trading could ensure that ALL your trades are profitable. So, how does it work?
Well, the martingale strategy relies on the principle of mean reversion, which dictates that less probable events are eventually followed by more likely events. When applied to trading, the exact rules become:
Each time you lose, double your position size.
Each time you win, cut the position size in half
In other words, we lower our average entry price, by constantly adding to our positions when we experience losses. The main idea is that eventually there will be a winner that compensates for all the previous losses.
In other words, we do not close a position before we have had a profit, effectively leaving the whole concept of stop losses untouched.
While the idea that a losing trade eventually is followed by a winning trade is true, the exponential growth of the loss during the losing streak will eventually lead to bankruptcy!
As its name implies, the anti-martingale approach is the opposite of the martingale method. Instead of adding size to losing trades, we add to winning trades and cut losing trades in half. So the rules become:
Each time you win, double your position size.
Each time you lose, cut the position size in half
The anti-martingale approach is better than martingale in the sense that it limits risk to the downside by cutting positions in half after each loss. However, this and the fact that the position size is doubled after each winning trade has two effects:
- Since you increase the position size for each winning trade, once you get a losing trade, it has the potential to offset all the profits you have made so far.
- If you happen to experience several losing trades in a row, your position size will be very small once the losing streak is over. Therefore you will profit very little from the rebounding market.
In other words, a purely anti martingalian approach is probably not the best choice either!
Which Should You Choose?
It is understandable that all the options we have presented may cause some confusion as to what approach you should go for. However, the best thing is to not complicate things more than necessary. As such, we recommend that you go with one of the two methods presented in the beginning. Those were:
- Setting the stop loss as a fixed dollar value. Preferably, this is not more than 2% of your total account value.
- Setting the stop loss so that you never risk more than 2% of the total account value. Unlike the first method, the amount you risk constantly fluctuates with the current account balance.
We ourselves seldom complicate things beyond these two methods, and we are sure that you will find that it works well for you too!
Different Types of Stop Losses
While calculating the amount that we are willing to risk at most is important, we also need to know where to place the stop loss. Even if we can risk $1000 on a trade, in order to know how many shares or contracts we can buy, we need to know where the stop loss should be placed. That way we can calculate the risk per share/contract, and find the optimal position size for that trade!
The Importance of Choosing the Right Stop Loss Level
The placement of the stop loss level and its distance to the entry is very important in order to take full advantage of the trading strategy. If you use a too tight stop you could end up being stopped out of a trade too often, which could adversely impact the performance of that strategy.
This is a tendency you will see with many strategies. Sometimes the required stop loss could even make the strategy impossible to trade since it is too big. This typically is the case with mean reversion strategies that tend to need quite large stops. In general, mean reversion strategies really could be said to be a special case when it comes to stop losses, and that is why we will cover this in a separate section of the article!
However, there are also trading strategies that might not work at all if you do not limit the losses quite stringently. It all really comes down to the trading strategy type and you will have to constantly test what suits your trading best!
Simple VS Complex Stop Loss Types
Of the methods we are going to cover, some might seem better than others. For example, it is quite tempting to use a stop loss that adapts to current volatility levels, since it might promise better performance.
However, while the more complex solutions work sometimes, you would be surprised how many times the opposite is true. In your trading career, you will many times find that theoretically sound ideas do not work as expected. The market behaves as it does regardless of how you think it should!
Therefore it could be good to know some different ways of determining where to set the stop loss, and not skip the simple methods! Let’s get to it!
1. Dollar Stop
The dollar stop is the most simple of all methods in this guide. You simply set the maximum dollar amount you are willing to risk on each share in that trade, and if the market goes below that amount, you will be stopped out!
Now you might think that this is the same method that we used to determine how much we should risk on a trade. Well, it is not! Here we use dollars to measure the appropriate distance from the stop loss to the entry. This amount then must not exceed our maximum allowed dollar risk, and is calcualted on a per contract/share basis.
For example, we might choose to use a dollar stop set to $20. In that case, we will always put the stop $20 dollars away from the entry.
We use dollar stops a lot when we trade futures. However, they are not appropriate at all when you need set one stop loss at several markets, like when you trade a basket of securities.
This is because stocks trade at different prices. For example, a distance of $1 dollar might be appropriate to use on a stock that trades at $10, while it will be far too small on another stock that trades at $1000. In order to solve this issue, you will have to resort to…
2. Percentage Stops
Percentage stops become the solution to this issue. Instead of using a fixed dollar amount, you simply put the stop loss at a set percentage of the current price away from the entry. Since the stop level now changes with the price at which the security is trading, it becomes flexible and could be used across many stocks that trade at different prices.
For example, a 5% stop loss on a stock that trades at $100 means that you risk 5$ per share, while the same amount for a stock trading at $1000 becomes $50.
In other words, the percentage stop is a little more flexible than the dollar stop. Instead of using a fixed dollar amount that is applied to every trade, the percentage stop loss takes into account the size of the market.
3. Volatility Based Stop Loss
A volatility adjusted stop loss uses a measure of the volatility to decide where the stop loss level should be. Since volatility is changing all the time, having a stop level that is based on the current volatility levels could be of great value. Markets can experience great shifts in volatility, and by taking this into account we can avoid placing the stop loss too close or too far away from the entry.
In order to know where to place the stop loss, many traders use the average true range indicator. The ATR is an indicator that simply measures the range for each bar, and then creates an average of the x-latest datapoints. Here you can see the ATR applied to a chart:
As you can see, the higher volatility, the higher the ATR value. In the very last reading in the above image, we see that the ATR was around 6.
Typically, you take the ATR reading and multiply it by 2-3, and then set the stop loss that far from the entry. If we were to do that with the example above, we would get 6*3=18. Since the y-axis is shown in dollars, this means that our stop loss should be placed $18 from the entry.
Another great way to set a volatility based stop loss is to use Bollinger bands.
Bollinger bands work by taking the average of price x-bars back, from which the standard deviation(typically multiplied by two) is subtracted and added to. This creates three lines:
- The upper line, which is placed 2-standard deviations above the moving average
- The moving average
- The lower line, which is placed 2 standard deviations below the moving average
Here is an image of Bollinger bands applied to a chart
Depending on what type of strategy you are trading and where the entry is in relation to the outer bands, these could work well to determine the stop loss level.
For example, if the market is in an uptrend, you will probably enter in the higher regions of the Bollinger band channel. In that case, the lower band might serve as an excellent stop loss level!
4. Time-Based Stop Loss
Time stops might not fall strictly under the stop loss category, but depending on how they are used, they definitely could be used to limit losses!
Many trading strategies use logics where the trade is exited either through a profit target, or a stop loss. This means that as long as the market does not hit the stop loss or the profit target, you could remain in the trade for a very long time.
However, what you might find with some strategies, is that the edge you entered on fades the longer time you keep the position open. If that is the case, it could be wise to exit the trade if a specific amount of time has elapsed since the entry. Since the edge is fading, that also means that you probably save yourself a few losses!
5. Trailing Stop Loss
Trailing stop losses really are in a category of their own! While the other types of stop losses we have covered have their exact level set at the time you enter, a trailing stop loss has its level shifting constantly, trailing the movements of the trend.
In order to know where the exit level should be at any given moment you most times either use a moving average, or simply set the stop loss at the lowest high or highest low x- bars back. Let’s have a look at the two alternatives to make it a little clearer.
In the image, you see how we entered a trade at the beginning of the uptrend. Since our goal here was to catch as much of the upcoming trend as possible, we decided to let the moving average act as our trailing stop. In other words, it not only became a protective stop loss but also our exit method.
With the help of the moving average, we managed to catch a significant amount of the following upward movement. It nicely trailed the price, and once it finally broke through the moving average, that was our sign that the upswing was over for this time, and that it was time to realize our profit.
Let’s also give a clear example of what a trailing stop loss using the lowest close of the selected time period look like. In this example, we will set the time period to 3, and track the lowest close with the help of donchian channels.
As you can see, the stop level is moving higher with the higher closes. Then, when the close crosses under the three day low, we exit the trade.
Trailing stop losses are mostly used with trend following strategies, since they provide a nice way of capturing the big moves. Trends in the market can persist for a long time, and by using a trailing stop you increase your chances of not being stopped out too early!
Combining Stop Losses
When you use some of the stop loss types, the size of the stop loss will change with the market. For example, the volatility based stop loss varies with the volatility of the market.
In order to not take too much risk in a trade, you will have to set a dollar limit that applies to the trade as a whole. Since the stop loss amount varies with the current market conditions, you could find yourself in a situation where you risk too much because the distance to the stop loss has become too much. In such cases, a dollar stop loss is crucial to ensure that a trade never risks too much of your trading capital!
The Different Stop Loss Order Types
Regardless of which type of stop loss you choose, you will have to choose between two different stop loss orders. Both have their advantages and disadvantages, and depending on what you want to accomplish, one might be better than the other. Let’s cover what they are, how they work, and their advantages and disadvantages!
Stop orders are orders that are turned into market orders as soon as the stop level is hit. A market order is an order that simply is executed at the closest available price in the market. This means that you potentially could end up with some excessive slippage, in case you are trading a not so liquid market, perhaps during high volatility.
Stop Limit Orders
Stop limit orders are a little more complicated and could be said to consist of two parts:
- A stop order, that is activated once the price reaches a specific level
- A limit order that is the order that gets activated by the stop order
So, what happens is that you set a stop level, like with a regular stop loss. However, what differs is that once the stop level is reached, instead of a market order, a limit order is sent out!
For those who do not know what a limit order is, it is an order that will only be filled at the limit price or better. For example, if your limit price is $100 and you want to go long, the limit order will only be filled at $100 or below.
In other words, when using a stop limit order, you must define both the stop level, as well as the limit level. Here is an illustration of a stop loss together with its limit level.
In case that price touches the stop level, that would trigger the limit order. Since the limit level is under the stop level, that means that your position will be closed anywhere above the limit level, but not below.
The fact that you can customize the limit level and the stop level, means that a stop limit order adds a lot of extra flexibility. This could be great if you decide that you want to exit your position in case the market drops below the stop level, but are not prepared to exit below a certain price. By using a limit order you can make sure that your position is not exited at a price lower than your limit level.
Stop Orders vs Stop Limit Orders
Since a stop-limit order comes with more flexibility, you might think that its the obvious choice. However, although limit orders give you more control over your trades, they also come with additional risk.
A good example would be if a security is in free fall. In such a case, there is a chance that your whole order is not executed. For example, let’s say that you had an open position that hit the stop loss level, and the limit order was executed. Let’s now assume that the market continued to fall beyond your limit level before the whole order had been filled. In this case, the remaining parts of your order will not be filled until the price of the security once again rises to the limit level and your broker is able to find willing buyers.
With a market order, you are guaranteed to have your order executed, as long as the market operates normally. However, what you do risk is to have your positions sold off at a level you deem inappropriate. For example, if you are sending a market order into an illiquid and volatile market, you might have to accept to go lower in order to find buyers!
Still, it is worth noting that this rarely becomes an issue with liquid markets!
Be Careful With Day and GTC Orders
When dealing with all types of orders, you must decide how long the order should be active. There are three different order types that are commonly used:
- Day Order– Is Cancelled by the end of the trading session, if not filled earlier
- GTC order(Good ‘Til Cancelled) – Even if the name states that a GTC order is active until it is canceled by the trader, it is normally removed automatically by the broker after 30-90 days.
- GTD order (Good ‘Til Date)– This order is active until a set date that you decide yourself
When you set a stop loss it is important to ensure that it is active as long as you have an open position. This means that a swing trader should not use a day order, since he or she will hold trades for several days. Conversely, a day trader should not use a GTC or GTD order, since he or she will never hold any positions after the trading session has closed!
Many trading platforms take care of this for you automatically, but it could still be good to know the difference between these three order types!
Stop Losses in Mean Reversion Strategies
Using stop losses in trading is one of the most important things you can do to limit your losses. By ensuring that a single trade does not wipe you out completely, you increase your chances of success!
However, when it comes to some types of strategies, using a stop loss can make more harm than good. Mean reversion strategies are some strategies where this applies. In order to understand why this is, we need to understand what mean reversion is.
In trading, mean reversion is the tendency of markets to perform too large swings that are followed by a reversion to the mean. Strategies that make use of this tendency are called mean reversion strategies, and try to identify when the market has gone too far in either direction.
Now, if we enter a mean reversion trade and expect the market to turn around because it has gone too far, the more it goes down, the greater the likelihood that it will indeed turn around. Thus, once our stop loss is hit, the edge has become even stronger than it was before we entered. Exiting at that point is not optimal by any means!
In our trading, we usually do not use stop losses for our mean reversion strategies. However, that does not mean that we are reckless! Since we are algo trading up to 100 strategies at a time, only a few of those are mean reversion strategies, and as such our risk is fairly limited at the portfolio level.
When it comes to dangers associated with stop losses, there are especially two that you should be aware of.
A gap in the market is when a security opens higher or lower than it closed the prior session.
Gaps in the markets are quite common and might deter some people from wanting to hold their positions overnight.
The main danger with gaps is that the security may gap beyond your stop loss level. For example, if you had a stop loss at $120 for a stock that closed at $121, and it then opened at $110 the following day, your stop loss would fail to limit your losses. Depending on whether you used a stop loss order or a stop loss limit order, two things could happen.
- Stop order: A market order is sent at the open of the bar. This means that you get out of the trade, but far lower than your stop level.
- Stop limit order: If the limit level was set above $110, you will not be brought out of the position, unless the market rebounds and gets over the limit level again.
As you can see, the impact for both order types could be quite serious and put you at risk of incurring far larger losses than you had anticipated!
Setting the Stop Loss Too Tight
It is not only with mean reversion strategies that stop losses hurt performance. Many trading strategies, although it does not apply to all, perform worse with a stop loss. Even if it is placed at a reasonable distance from the entry.
However, what is evident is that all strategies can be ruined if the stop loss is set too tight. Markets do not move in a straight line from point A to point B, and as such you must factor in the randoms swings and ensure that your stops are not hit too often.
In order to find out which stop loss distance is optimal for your trading strategy, we recommend that you use backtesting!
Stop Loss at Portfolio and Strategy Level
What we have discussed in this article is mainly having a stop loss at the strategy level. However, what arguably is equally important is having a stop loss at the portfolio level! By this, we mean that you should have some sort of protective mechanism in place that comes into force when the drawdown passes a certain threshold. Such a protective measure could be to decrease the size of your trades, or to maybe stop trading completely for a while.
In our algorithmic trading course, we cover this in-dept! Here you can read more about algorithmic trading
What Is Stop Loss Hunting?
Stop hunting is a strategy employed by traders who seek to take advantage of the fact that many stop loss orders are placed around the same levels. Once such a level is penetrated, a wave of stop loss orders will hit the market, subsequently increasing volatility and pushing the market lower.
Traders may then try to profit from the increase in volatility that offers them more trade setups, or try to buy the dip and cash in on the rebounding market.
Stop losses are vital in trading. They help limit risk and should not be overlooked by any trader. Despite this, there are occasions when implementing a stop loss might not be the best idea. Mean reversion trading is such a trading form, where a stop loss could make more harm than good!