If you have ever traded before chances are you’ve taken a losing trade at one point or another. As frustrating as they can be, losses are a normal part of trading. Luckily they can be managed and minimized in order to maximize trading profits.
In this article, we will deep dive into the importance of stop loss orders.
We will go over :
- What is a stop loss
- The importance of a stop loss in risk management
- How to optimally place it
- Liquidity hunting
Let’s dive right in.
What is a stop loss
A stop loss is an order used to close out a position with a market order if a certain price is reached. If a trader is long a stock at 100$ and places a stop loss order at 99$, the stop will close the long position with a market sell order if ever the price reaches 99$. This order type can also be used on short positions with buy stop orders. By using stop loss orders effectively, traders can protect themselves from significant market downturns and unexpected price movements
The importance of a stop loss in risk management
Now that you understand what a stop loss does you can understand what it is used for. The primary goal of a stop loss is to limit losses on a particular trade. Stoplosses will use a market order meaning there will be slippage [link] but it will still stop a loss from becoming too big.
It is important to cut losses and have a predetermined risk per trade as this will help you reach a positive expected value [link] in your trading. For more information on risk per trade and position sizing I would recommend looking at the article I wrote on risk management [link]. Cutting losses is one of the keys to profitable trading as it can ensure a positive expectancy.
How to optimally place a stoploss
Ideally you want your stoploss to be hit as little as possible to profit on the highest amount of trades. Naturally you will have to figure out the best place to place your stoploss. Determining the optimal placement for a stop loss order requires careful analysis and consideration of various factors. Here are a few strategies that I personally have found useful can consider:
1. Daily Highs and Lows
Placing a stop loss order beyond the daily high or low can provide a good stop location in trending market conditions [link] . If the price breaks through the high or low of a previous day, it suggests a potential change in the market trend and can be a precursor to a larger telegraphed move in that direction. The stop loss can help limit losses in such scenarios.
2. Swing highs and swing lows
Market swings are prices that traders use to identify potential price targets. Placing a stop loss order beyond swing can help protect your trade granted the swing is chosen correctly [link]. This technique allows traders to capture potential gains while minimizing losses if the anticipated move fails to materialize.
The above picture has swing highs being respected as the S&P 500 future makes new lows. Notice how the market does not break any swing high as the down trend persists.
3. Key levels based stops
Utilizing key levels can provide guidance for stop loss placement. Key levels work in a lot of cases because of the trading version of supply and demand [link]. A good way to find key levels is to look for ranges on a higher time frame then the one you are trading. If you are trading the 5M or 15M chart, a key level from the 1H or 4H chart can be effective. Placing your stop above these key levels can be great for breaks and retests or breakouts. This strategy works best in range bound markets [link].
These strategies or a mix of all 3 of them will be immensely helpful to avoid false stopouts and with practice can help you win a higher percentage of your trades.
Liquidity Hunting
Even with these strategies the market will still have challenges to navigate when placing stops. The goal of a market is to facilitate trade and this is done through liquidity hunting. For more details on this I would check out my article on liquidity here [link]. Put simply, liquidity hunting refers to the practice of large market participants deliberately triggering stop loss orders by temporarily pushing prices to levels where a cluster of stop losses are located. They do this to accumulate or distribute a large amount of a financial asset at a specified price. This means that even with the above strategies from before there can be liquidity grabs that cause you to get stopped out. It is important to thoroughly backtest any strategy before trading it with live money to understand what can happen.
Avoid placing stop loss orders at levels that are easily identifiable. Round numbers or commonly used support or resistance levels are easy to spot on a chart and many people will use them making institutions more likely to hunt liquidity in these areas.
It is also best to have multiple factors that align on where you place you stop to increase the likelihood of it working. For example a long position stop placed below a level of support that is also the previous day’s low is better then a stop placed only below a level of support. The more factors of confluence used for a stop location typically makes the location better.
Conclusion
Implementing effective risk management strategies is crucial for traders seeking long-term success. The use of stop loss orders plays a vital role in managing risk by limiting potential losses and protecting capital.
Optimal placement of stop losses, considering factors such as daily highs and lows, key levels and price swings allows traders to balance risk and reward.
As market primary goals are to facilitating trade, protecting your stoploss will be the key to victory.
Just remember to always manage your risk while doing so,
Let me know what else you would like to learn and follow for more.
Cheers,
Andrew Akl
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