Strategies for placing your stop loss

Using a stop loss is a great first step in taking the psychological element out of your trading, by automatically closing a losing position that you might have otherwise let run.

IG analyst Joshua Mahony introduces three methods for placing your stop loss in 2016

Where to place your stop? Place it too far away, and you could be risking too much on each trade. But place it too close, and your position could get automatically closed due to short-term price fluctuations, incurring a loss on a market that’s actually destined to recover.

Using a stop-loss strategy can help with this problem, by identifying the right places to put stops to ensure that you are making the most from your trades.

The different types of stop

There are three main types of stop that you might want to consider employing in your strategy:

  • Basic stops will close out your position when a certain price is reached. They can be affected by slippage if the market moves beyond your specified price before your provider can close your position
  • Guaranteed stops work like basic stops, but can’t suffer slippage: they’ll always close your position at the price you specify. If your guaranteed stop is triggered, you’ll have to pay a small premium
  • Trailing stops follow the market if it moves in your favour –  and when the market turns, your position will close out at your trailing stop’s new level

Three popular methods for placing your stop

The 2% rule

One of the simplest stop-loss strategies, the 2% rule works on the principle that you never risk more than the 2% of your total trading capital on a single position. Traders who follow this principle believe that by only ever risking 2% of your capital on each trade, you can ride out several losing trades while also taking advantage of profitable opportunities.

To apply the 2% rule to your stop-loss strategy, take 2% of your total trading capital and place your stop at the point where your position would lose you that amount – while remembering to take the spread into account.

For instance, you have £10,000 to trade with, and want to spread bet on the FTSE 100 at £10 per point. As 2% of £10,000 is £200, according to the 2% rule you can afford the FTSE 100 to move 20 points against you. So you’d place your stop 20 points from the opening price, plus however much the spread is.

While it can be useful in ensuring that you don’t lose too much capital on a single trade, the 2% rule doesn’t take any short-term volatility into account. On a volatile market like bitcoin, for instance, you could get closed if the market briefly retraces as part of a larger upward movement.

Support and resistance

Support and resistance are the areas on a chart where a market’s price movement is likely to reverse. When a market’s price breaks through an established level of support or resistance, it will often see a sustained move in that direction – this makes them useful for deciding where to place your stop.

When using support and resistance levels as part of your stop-loss strategy, you’ll want to put your stop slightly beyond the established level of support or resistance so that your position is closed before the market moves too far in the wrong direction.

For example, if a market you have a long position on has repeatedly hit a low of 200, you might want to consider placing a stop at 195 to close your position once that support level has been broken.

The simplest way of identifying support and resistance levels is by using historical prices. But there are also lots of technical indicators that can help, including:

  1. Pivot points: adding a pivot point to a chart will give you the average of the high, low and closing prices from the previous period (usually one day), which can be used as support and resistance levels
  2. Moving averages: in particular, a market’s 50, 100 or 200-day moving average is often seen as a key area of support against a downtrend or resistance against an uptrend
  3. Bollinger bands: plotted two standard deviations away from a simple moving average, Bollinger bands can be used as an indicator for support and resistance levels

Average true range

Using indicators to identify support and resistance is one strategy for placing stops – but there are a few ways that technical analysis can inform your stop placements. One popular alternative involves using the average true range (ATR) indicator.

When you add an ATR indicator to a chart, it’ll show the average volatility of the market over the past 14 days. So if the current ATR of the market you wish to trade is 20, it’ll have moved 20 points on average each day over the past 14 days.

You’ll want to take a percentage of your chosen market’s ATR to dictate how far away you place your stop. The percentage you take will depend on the market you are trading, and how long you plan on keeping the position open for.

ATR is a useful part of a stop-loss strategy because it is dynamic – you can adapt your stop placement to match different market conditions.

Every trader is different, and employing a stop-loss strategy that suits your trading style is important. So if you’d like to try out different stop-loss strategies without risking any capital, open a demo account to start testing what works and what doesn’t.

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