One of the standard refrains that a lot of trades have is that when they place a stop loss, it invariably tends to get triggered. That is not too surprising. Quite often our stop losses tend to be placed at the wrong level. Secondly, we tend to become either too aggressive or too conservative with respect to stop losses and that tends to work against the trader. Thirdly, stop loss is as much an art as it is a science. Very often traders tend to place stop losses too mechanically based on the technical levels. In fact, stop loss placement is also an art because you also need to tweak the levels based on your judgement of the market.
Let us quickly get to the concept of a stop loss
A stop loss order is an order placed to close a position at a certain price point in order to limit one’s losses. As the name suggests, one uses a stop loss in order to limit one’s losses where a trade idea works against us. Let us first look at why it is important? Stop loss is an important pillar of risk management. Therefore, poor stop placement and stop loss management can cost you a lot of money. Let us look at what the reasons why the stop losses go wrong. More often than not, it is a problem with the placement of the stop loss. Here is why stop losses don’t really appear to work and this is how to avoid it.
1. Have a clear idea of stop loss placement well in advance
Stop loss has to be thought through before the trade. It cannot be an afterthought. You should know where your stop is going to be before you open a trade. The benefit of ascertaining your stop before you open a trade is that it removes any emotions from the decision, because you have not yet risked your capital beyond what you can actually afford. The bigger problem is when you don’t have a predetermined stop and the market starts moving against you. Then you react to the market triggers without considering whether your trade idea has actually been invalidated or not.
2. Stop loss must have a method to the madness; it cannot be arbitrary
To cut a long story short, your trading framework must fit to the market. Don’t expect the market to fit your trading framework. That is when your stop losses become arbitrary. So, deciding where to place your stop loss should be predicated on technical charts. Normally, the thumb rule is to put stop losses for longs below the support and the stop loss for shorts above the resistance.
3. Stop loss should be based on a reasonable risk-reward ratio
This is something most traders tend to forget. Stop loss is a risk protection but it is also a loss event. If you take a risk of Rs.3, you must at least earn Rs.6 on the positive side. That is a positive risk-return trade-off of 2:1. A ratio of 1:1 is hardly a smart strategy. You are committing capital where you are not being compensated adequately for your risk. Your breakeven point should be such that it is worth taking the risk. At the end of the day, the market does not care where you entered and where you break even. That is your task to figure out and that is where the risk reward ratio comes in.
4. Don’t get biased by liquidity when setting stop losses
The rule here is to avoid placing your stop loss directly above or below the key swing highs / lows. These points tend to offer a lot of liquidity but that can hardly be a valid criterion to set the stop loss. Quite often, traders tend to gravitate towards liquidity while setting their stop losses but that tends to distort your trade. In a nutshell, do not place your stop losses in really obvious places because they will never work.
5. There is no sanctity to a stop loss and you can move it
The whole purpose of a stop loss is to protect your position if your trade idea is incorrect. What do you do if the price moves in your favour? You can always move the stop loss to keep your risk-reward in balance. Some also call it a stop profit zone but it does work well. It is not like if you shift your stop loss, you are not having conviction. It is just that you are being practical and moving your stop according to the changing market conditions.
In short, when stop losses get triggered too often, you need to get back to the drawing board. The problem is often more structural or conceptual in nature.
What is your experience with setting stop loss? Share it as comments!