Ok I’ll admit it, stop losses aren’t an exciting read and writing about them isn’t going to win me a Pulitzer Prize either. But they are one of the most important aspects of trading so they must be covered. Whether to prevent excessive losses or to lock in profits, all investing styles benefit from them. So in this piece, I’m going to look at stop losses and different strategies for where to place them.

What Are Stop Losses?
First up, to get everyone up to speed, a little definition of a stop loss is needed. So without further ado:

A stop loss is an order to close an existing trade at a pre-set level, designed to limit any possible loss.

If you need more a refresher on the basics behind stop losses, check out Tutorial Two of the Trader Academy.

paddypowertrader rate this important tool of risk management so highly that they include a mandatory stop loss order with every opening trade. The stop loss order level is automatically chosen, usually at 80% of the Max CGSL, which is the required margin to enter the trade. For example, the Max CGSL for the GBP/USD Rolling Daily is 200 so if you traded GBP/USD, a stop loss order would be created 160 (80% of 200) away from where you got in. This level is very unlikely to be the optimal stop loss level. So it’s up to every trader to go into their order book and find their optimal level. This will vary from trader to trader and I will go over a few different strategies now.

Different Strategies For Setting Stop Loss Levels

(1) Support And Resistance Levels
First up is the classic strategy for finding a good stop loss level. Support and resistance levels are points on a chart where the probabilities favour a halt, or even a reversal, in the prevailing trend. They form the backbone of technical analysis and have a background in trading psychology. When a price is approaching a support or resistance level, traders often go weak and bail out of positions as they don’t want to be the person to attempt to push the price through the level. This often leads to markets stalling and reversing at these levels. So when going long, the aim is to identify a level of support and place the stop loss order just below that level. In contrast, when placing a short trade, the aim is to find some resistance and put the stop loss slightly above that level. The image below shows some very solid resistance on the USD/NOK daily chart.

(2) Highs And Lows
Next up are highs and lows. The theory behind using them is the same as support and resistance. Traders possess a mental block that it makes it more difficult for the price to push through to a new high or low. The type of high or low that you use depends on your timeframe for trading. For example, a medium term trader might look at a 52 week highs and lows, whereas a day trader may look at the daily high or low. In general, lows provide support and highs give resistance.

(3) Parabolic SAR
On the paddypowertrader charts, there is a handy little technical indicator called the Parabolic SAR. One of its main uses is to determine where to put stop loss levels. If you are going long, place the stop loss order where the green dot is on the chart or if you are planning on shorting, put the stop loss where the red dot is. It’s a simple, but often very effective, strategy for setting stop losses.

(4) Tight Stop Losses
Often tight stop losses can be an optimal strategy. A lot of emotional control is needed here as this strategy will result in a lot of losses being taken. The hope is that the relatively fewer wins will more than compensate for the losses. Tight stop losses tend to be more suited traders looking to call a reversal in a market. They put their stop loss as close as possible to their perceived key reversal point and then hope that the market reverses. For example, the FTSE hovers around a key support level before slightly moving up. A trader could go long in this situation and place a top loss order just below the support level. Day traders tend to use tight stop losses more as they like getting in and out of traders frequently throughout the day.

(5) Loose Stop Losses
An alternative approach is to apply a much looser stop loss, thus giving the trade more room to work in. Markets these days are often very volatile where huge swings are not uncommon. Traders refer to this as “noise” in the market. Looser stop losses are one method to overcome this “noise” as they help to offset the risk of getting stopped out despite the fact that the trader called the overall move right. Loose stop losses tend to be used more in trending markets and employed more by medium term traders who prefer to sit on positions.

(6) Timed Stop Loss
Time stops are used by traders because they enter in buy or sell orders expecting a certain move to occur. If the expected move never occurs and the reason the trader initiated the trade is no longer relevant, then the trader should exit their trade. With paddypowertrader, timed stop losses must be managed manually by the trader as there’s no feature to close a trade at a precise time. This brings human emotions into the equation. Don’t be tempted to leave a trade open for any longer than is optimal.

(7) Trailing Stop Losses
When your trade is winning, a further stop loss strategy comes into play called trailing stop losses. Simply put, they are a stop loss that is adjusted as the price moves in a trader’s favour. The aim is to reduce risk and protect profits, by protecting the downside, whilst allowing traders stay in their trade. Mr FT has given a great account of this strategy before in his piece on trailing stop losses, so I encourage you to check it out.

Like when initially setting stop losses, the Parabolic SAR comes in useful for trailing ones too. Inline with the moving Parabolic SAR, the stop loss is gradually raised for a long position and lowered in a short position, effectively locking in profits. The chart below shows how you would trail your stop loss behind a winning long trade.

Conclusion
Although not that interesting, stop losses are the most important part of risk management. All traders must master risk management to becoming a successful trader. Exactly how you choose to set your stop losses is up to you, but if you can’t do it properly, it’s unlikely that you’ll be too profitable. Be confident in your strategy and carry through with it. Stop loss orders can help you stay on track without clouding your judgment with emotion. A bulging account may be the result.