For most people new to the markets, the phrase “stop loss order” carries with it an ominous connotation. Images of foreclosure signs and overdrawn bank accounts come to mind, both products of a once-promising opportunity gone awry. However, for veteran traders, stop losses are not viewed as foe ― they’re a powerful tool for avoiding financial catastrophe.
Stop Loss Order Placement ― It’s a Science
At its core, the purpose of a stop loss order is to limit the liability of an open position in the market. In the event price moves against market entry (down for a buy, up for a sell), the stop loss closes out the position at a predetermined point. So, the million dollar question for active traders is this: Where should I place my stops?
As any veteran of the markets will tell you, becoming competent in using stop losses is the key to sustaining profitability. Of course, there’s much more to accomplishing this feat than meets the eye. In practice, you can exit a trade anytime you want to, but the “art of the stop loss” lies in understanding when a trade is truly over, not just struggling momentarily.
Here are several ways that professional futures traders determine the location for a stop loss order:
- Time: For many short-term traders, stop losses are defined according to time. As an example, end of day (EOD) stops are used to flatten a negative position just before the session’s closing bell rings. EOD stops eliminate the potential liability of holding an underwater position through the electronic close.
- Technical tools: For technical traders, there are literally thousands of ways to identify stop loss locations. Fibonacci retracements, moving averages, and candlestick patterns are a few indicators used to determine when to exit a negative trade.
- Price action: In the cases of breakout and momentum traders, price action itself is frequently used to decipher where a stop loss should reside. Trailing stops serve as a good example of this philosophy because they move in concert with evolving price action and aren’t subject to precise placement.
- Market structure: The definition of market structure is nuanced and often differs depending upon who you talk to. Classifying price action of different durations in terms of consolidation, trend, or rotation is a largely subjective endeavor. Nonetheless, stop losses are frequently placed above periodic highs, beneath periodic lows, or within defined trading ranges.
Determining the best stop loss order location for an individual trade directly depends on the strategy you’ve implemented. Remember, for a protective stop to be effective, it must properly balance risk and reward, yet give the trade a legitimate shot at success. Excelling in this area is a fine line ― if a stop is too tight, it’s likely to be hit; too loose, and account drawdowns can become severe.
Stop Loss Psychology
If you have any experience at all as an active trader, then you’re familiar with the frustration of exiting a position in the red. It can be an emotional event, one that symbolizes both defeat and capital loss. In many cases, the market reverses shortly after a position is closed ― seemingly to rub salt in your wounds.
Unfortunately, avoiding this scenario is simply not possible. If you’re going to trade, then you’re going to occasionally lose money. However, your ideal stop loss order location can be anything you want it to be, and, as long as you are profitable, it’s correct.
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