Stop Losses
The number one thing you can do to protect capital, and increase your odds of success and longevity in trading is managing your risk. One of the more difficult aspects of trading is knowing where to place a stop loss. Time and time again, stop loss runs and desire to protect capital leave traders with stop losses that hit only to then watch their thesis play out. This is very dangerous, because it will lead traders to the wrong conclusion that they shouldn’t use stop losses, rather than thinking how they can use them more appropriately. But time and time again, stops will hit, and protect you from further losses, which is the point, we just often forget these times compared to the times where instead we missed out on gains. Managing stops will absolutely lead to missed opportunities, but it will more often than not prevent you from assuming too much risk, taking bigger losses, and keep you in the trading game a lot longer.
The key to stop losses is in deciding when your thesis is wrong, and applying that with both the principles of technical analysis, and human psychology.
3 Ways to Use Technical Analysis for Placing Stop Losses
1. Higher Lows
Trailing stops, ones that move up your stop with the move of the stock, are a great way to protect your winning position as it extends higher. However many trailing stops are based on arbitrary dollar amounts, rather than the fundamental nature of the trend. For example a .50 cent trailing stop on a stock will trigger as soon as it goes down 50 cents from any given high, but what if the technical support is 54 cents away? So we can use technical analysis to create a manual trailing stop. The idea is that as the stock continues to make higher lows in the time frame of your trade (example the daily time frame uptrend of higher lows and higher highs remains intact), you would manually walk up your stop under the last higher low, so that you only stop out if the nature of the trend changes.
In the below example with Bitcoin on the 4H chart, if you had an auto trailing stop of 3% following price, you can see you’d get stopped out after the second leg on the move. Technically there’s nothing that invalidates the 4H uptrend but with auto trailing stops you’re taken out of the trade.
2. Moving Averages
Oftentimes in breakout charts, a stock will ride up along a given ema acting as support, typical EMAs to use are the 9 period simple moving average, or the 12 period exponential moving average. As long as the stock continues to hold that moving average, on the time frame of your trade, you would remain in the position, with the stop hitting on a candle closing under that moving average, like in the following example.
3. Target Doesn’t Hit
Sometimes when we have a plan with an initial target, the trade moves towards the target, but doesn’t quite hit your exit plan. In these circumstances, it can be worth using a trailing stop of sorts. Imagine the scenario where you enter at 100, and target 105 on the trade, with an initial stop under 99. If the stock keeps going towards your target, hits 104.50, then starts to pull back, this is where the new 2:1 trailing stop would kick in. Essentially you don’t want to give back more than a 2:1 risk from the new level you’re at, so if you hit 104.50, you are 50 cents away from target, you would raise your stop to 104.25, so that you don’t give back more than half of the 50 profit you would make should your target have hit. If instead you trade towards 101, then immediately start to pull back, you could raise your stop to around breakeven so as not to turn a winning trade into a losing trade, while still trying to maintain the trade in case the thesis does in fact play out.
Psychology of Stop Losses
The market will frequently breakout, then retest lower to run stops before continuing higher. Many consolidation patterns including bull flags will include slight breaks of support with no follow through. When placing your stops, it’s often good to give yourself a bit of cushion below prior levels, but not too much, in case you are looking at some quick stop runs. In our Guide to Entries, we describe how you can even use these stop runs as potential entry points.
Psychological Levels
If you enter a stock at 100.2, it’s worth putting your stop at 99.98 (assuming 100 is support) instead of 100, as often psychological levels will get tested, but act as a base of support keeping you in a trade for only an extra cent or two of risk. In the example below, Bitcoin broke psychological $70k with no follow-through.
Volume and Liquidity on Stops
In heavy volume names, stops can be quite tight with respect to support levels. In lower liquidity stocks, or stocks with large bid and ask spread, it’s important to give a little wiggle room on stops, or recognize that manual stops might be more effective as stop runs are more frequent.
Key Points Summary
Stops are an important tool for managing positions, and increasing longevity in a volatile market. Using technical analysis and psychology can help you place your stops to maximize reward, while still mitigating risk. Trailing stops, backup exit plans and other tools/indicators can help you remove emotion from the equation in taking profit, or exiting losing trades.
See also: 4 Top Exit Strategies
