Risk management is by far the most important component in any trading system. While stock selection is important, risk management is the key to longevity in the market.
All else being equal, a trader with poor stock selection and sound risk management will outperform and survive longer than the trader with great stock selection and poor risk management.
Stop losses are a key part of this process. They’re like insurance bills, which you hate paying until coverage is needed. But just setting stop losses isn’t sufficient. Traders also need a sound strategy to keep risk inline and minimize needlessly getting stopped out.
What’s a Stop Loss?
A stop loss is a standing order to exit a position if its price crosses a certain level. Stop losses can automatically update (trailing stops). Or they can only execute if other conditions are true (stop limit).
However you use them, stop losses are one of the most common risk-management techniques in the market.
Risk management requires setting stops according to a system. Without rules governing risk areas, it’s not much of a system at all.
Once the proper risk is determined along with the entry price, a trader must calculate whether the distance to the stop price makes sense. Also, can they afford the potential loss based on their capital?
This risk should be pre-planned before the trade occurs and should not change once the trade is live. Traders also need nonnegotiable rules to keep risk per trade below a predetermined amount. (This is expressed as a percentage of assets in the portfolio.)
This keeps risk consistent and small. It also provides visibility about what would cause a major drawdown in an account.
Stop Losses and Position Sizes
The most widely accepted industry standard today is risking no more than 1 percent of a portfolio on any given trade. If a trader finds a desired position has too much risk based on their portfolio, they should avoid the trade or reduce its size.
Here’s an example of determining the position size for a trade using the 1 percent rule :
Position size = (Total account value * risk percentage ) / (entry signal - risk area)
Let’s illustrate with real numbers:
- Total account value (TAV) = $100,000
- Risk percentage = 1 percent
- Entry signal = $56
- Risk area = $49
Position size = ($100,000 * 0.01 ) / ($56 - $49 )
Position size = 1,000 / 7
Position size = 142 shares
That's the largest size that should be taken on this trade.
Traders must heed these points. While it can be tempting to go outside of one’s system or take a trade that looks especially juicy, it is important to think in a long-term manner.
Buying too many shares for a given risk area is a recipe for disaster. It can also inflict major damage to an account if only a few trades go wrong. Furthermore, oversized positions can wreak emotional havoc and cripple decision-making. Regardless of whether a system is quantitative or discretionary, rules must govern the amount of capital at risk.
Tools For Setting Stop Losses
Traders can determine stop-loss prices based on many techniques. For example, there are pivot levels on price charts or volatility indicators like Average True Range (ATR). Moving averages are also common. Like much of trading, “there are many ways to skin a cat.”
Still, remember that the market always tries to fool the masses and shake out weak hands. Often a stock will drop below an obvious stop and scare you away before resuming its trend higher. Traders can plan for this in a few different ways:
- Give more of a buffer by widening the stop and reducing the position size.
- Wait for a close below a certain level. That can offer more confirmation than just a few ticks.
- Use a confluence area to trade against so that there is less chance of price breaching the stop level. A confluence area is a place on the chart where multiple indicators line up. For example, a pullback-style trader might wait for a stock to retest an earlier breakout zone and a moving average. By having two areas of support and placing the risk below them, odds are tilted in their favor.
Also remember time frame impacts risk tolerance. A day trader using a one-hour chart for a signal should have much tighter risk than a swing trader with a weekly view. The key is to find an area within your time frame where price is unlikely to go. And then only cut the position if that level is reached.
In conclusion, most traders don’t spend enough mental energy placing stop losses. By going outside the normal day-to-day swings and considering the position size, big strides can be made toward long-term success.