Stop loss placement can be as much a matter of art as science. There is no one-size-fits-all answer to perfect stop placement, but read our suggestions about positioning your stop orders to tip the balance of probabilities in your favour.
Let’s start with a couple of rules:
Rule #1: You really don’t want to stop out.
Rule #2: If you do stop out, make sure it’s for the smallest possible loss.
Or, as the captain of the Titanic may have been wise to advise his passengers, “Don’t Panic! But if panic ensues, make sure you’re one of the first (into the life boats)”
Let’s look at how we might position our stop orders in order to satisfy these two rules. It’s more logical for me to consider the second rule first.
Rule #2 (paraphrased): Stop Out for the Smallest Possible Loss
When first placing a stop order on a newly-opened position, the aim of the game should be to protect yourself against your initial investment thesis having been wrong. If you buy a stock because the price appears to be rising from a low-point, a so-called ‘support’ level, you can conclude your investment thesis to have been proven wrong if the support level is breached. Place your stop order initially just below the support price, and make additional allowance for the bid-ask spread.
Contrary to what many novice traders and investors believe, it is usually far better to admit defeat quickly (but not too quickly) at the cost of a small loss than it is to hold on to an ever increasing loss in the hope of a recovery that might never come. Since the position of our initial support-based stop order is immutable, there is only one way to achieve a tight stop distance and therefore the smallest possible potential loss: buy as close to the support price as possible.
The bottom line here is that many novices position their stop orders at a fixed distance below their buying prices regardless of how likely those stop orders are to be triggered. Let turn this on its head, as shown in the diagram below, by determining our attractive buy-in prices (the green circles) relative to our ideal prospective stop level.
Rule #1 (paraphrased): Don’t Stop Too Soon
While we want to stop-out initially for the smallest possible loss if the price goes the wrong way, we want to hold onto any profitable position for as long as possible by not trailing our stop order upwards until we are safely above the ‘stop order danger zone’ (i.e. the price range within which our profit would not justify our initial risk or the possibility of having to re-enter the position). So we let the stop distance widen before trailing it, and we try to wait for a new support level to form, like this:
The bottom line here is that once we’re no longer in danger of stopping out at a loss, we want to stop out with the maximum possible profit.
About the Author
Tony Loton is a prolific trader and financial writer, and author of the book “Stop Orders” published by Harriman House.