Every trader or investor needs to have a stop loss, regardless of his/her strategy.
- You must make investment and trading decisions based on a set of rules.
- We always hope for the best, but we must prepare for the worst before we put on a trade or investment. We must know how to exit an investment/trade if it does not go as planned.
Here are a few systematic ways to determine where to put your stop loss. I also explain my preferred method.
A fixed % stop loss
The most common type of stop loss is a fixed percentage stop loss. This is advocated in trading books such as Market Wizards. Many traders, fund managers, and investors will cut their position if the market falls X% from where they entered.
I understand the logic behind this type of stop loss. A profitable trade should not begin with a massive loss. Most profitable trades work straight away or begin with a small loss and then become profitable. A trade that immediately loses 15% is probably not a good trade.
However, a fixed % stop loss might force you to cut your position at the worst time possible. Let’s say your stop loss is at 10%. What happens if the market falls 11% and then spikes 30%? You just lost 10% on a trade that could have been very profitable.
Stop loss based on support/resistance
This strategy is commonly used by technical analysis traders. They’ll draw their support/resistance lines on the chart.
- When they buy XYZ, they’ll say “I’ll cut the position if XYZ falls below $10 support”.
- When they short XYZ, they’ll say “I’ll cut the position if XYZ rises above $10 resistance”.
Here’s an example with gold.
This strategy used to work decades ago when there were fewer false breakdowns/breakouts. It doesn’t work well nowadays. There are too many false breakouts and false breakdowns. Large hedge funds will frequently smash the market below a support, trigger a lot of stop losses, and then scoop up shares on the cheap.
A trailing stop loss
Let’s assume that your trade/investment is profitable. Some investors/traders will choose to set a trailing stop loss. E.g. they’ll say “if the market falls below the 50 moving average, then I will take my profits and cut the position”.
The advantage behind this is obvious: you won’t turn a profitable position into a losing one (if the market keeps falling). You lock in your profit via the trailing stop loss.
The disadvantage is similar to a fixed % stop loss. Let’s assume your trailing stop loss is the 50 moving average. The market is going up, and you’re making money. Then the market falls slightly below the 50 moving average, you cut your position, and then the market continues to rally. You took a small profit on a position that would have been more profitable. You have no idea if a pullback is just a pullback or a bigger correction.
Stop loss based on case
This is my preferred method.
You should only cut your position if you think the thesis behind your trade/investment is wrong and no longer applies. Sounds logical right?
It is dangerous to arbitrarily cut your position based on a fixed % or technical indicator because you might cut your position at the worst time possible.
I only invest in the S&P 500’s ETFs via my Medium-Long Term Model. My model is based on a combination of technical factors, fundamental factors, and historical patterns. I have a Cut Loss Indicator that’s triggered when the thesis behind my position – my model’s indicators – change directions from bullish to bearish.
E.g. Let’s say I’m long UPRO (3x ETF for the S&P 500) right now because my model says the U.S. economy is improving. I will only cut loss when the U.S. economy starts to deteriorate. If UPRO falls 20% and the U.S. economy keeps improving, I will keep my position.
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