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How to Setup a Stop Loss for Your Trade

Trading without a stop loss is like rock climbing without a safety harness. One small lapse in judgement could spell catastrophe, (as so many traders have found out recently).

Two weeks ago, my business partner Chris Tate (www.tradinggame.com.au) and I caught up with Kris Sayce, your intrepid Money Morning editor and all-round gentleman. I’m still buzzing from the meeting. As we munched on our lunches, the three of us got into some really high level discussions about trading. We talked about what it means to achieve exceptional gains in the market, and why for some people, money just flows naturally into their trading accounts.

I really get a kick out of every time the three of us catch up, (and it’s not just because I enjoy looking at my own reflection in their shiny bald-heads). It’s because, when you meet with people like Kris, they tend to add clarity to your thinking that you just can’t beat.

Kris asked me for my advice about how to help his readers achieve even more exceptionally cracking returns. So I’ve spent all morning huffing and puffing, and stomping around my office in deep thought. Yes, I’ve even been talking to myself and ranting a little, scaring the neighbours dogs… and then all of a sudden – Whammo! I came up with the solution. Before I tell you what I came up with, to make sure we’re both on the same wavelength, take the time to…

  • Imagine what it would feel like to not worry about money.
  • Imagine unlocking the techniques used by the world’s best professional traders, every day of their lives.
  • Imagine knowing you’ve got a safety net so you never again feel fear while trading.

Well, if that’s what you’re aiming for, you’d better pay close attention to what I’m about to tell you.

The Solution

The simple truth is that without a clear idea regarding how to set a stop loss, you are sacrificing your future.

A stop loss tells you when to jump ship, and get out of your trade. I’m sure you know this – but have you really applied it? To join the elite inner circle of outrageously successful traders, your first aim must be capital preservation…

And this can only be achieved by setting a stop.

Yes, that’s right. If you aim to rake in the dollars, and this is your number one priority, money will cheekily skip away from you and jump into someone else’s pocket. Making money is a by-product of following your trading plan. Your plan must cover your entry rules, your exit rules and your position sizing methodology. Each of these three areas is essential to your success.

There are traders out there right now, making huge profits, while others around them are getting squashed. The difference between these two vastly different groups of people is the way they approach trading, and the methods that they use.

From the emails I’m getting over the past few weeks, many traders are struggling to find the best stop loss method to suit the current market conditions. Some haven’t even realised the importance of setting a stop loss, until they got run over by the rampaging bears. So, let’s start here and cover some of the basics.

Loss Control

Suppose you have $5000 to trade with, and you lose 50% of this amount. How much money in percentage terms do you have to make to breakeven on your next trade? If you automatically said 50%, this is incorrect. You need to make 100% on your remaining $2500, to make up the lost $2500, and break-even! Things are never as intuitive as they first appear. This table emphasizes the importance of keeping your losses small so that you can recover and continue to trade.

If you lose 25% of your account, you must make 33.3% profit on the remaining equity, simply to break-even. Keep your total equity drawdown to less than 20% and you have a chance of surviving in the sharemarket. Trading is not about avoiding risk – it is about managing risk.

Types of Stops

An initial stop is designed to protect your capital. Even successful traders find that they only make winning trades around 50% of the time. As long as the dollars gained outweigh the dollars lost, then you will be profitable, even if your hit-rate is quite low.

A breakeven stop will help lock in a no-loss trade. This type of stop is implemented once a trade has begun to co-operate and there is now little threat of your initial stop being hit. At least when you have moved your stop to breakeven, there is a chance that you will end up with a profitable trade. Especially with the application of leverage, it is important to move your stop to breakeven as soon as reasonably possible. This will minimise the potential drawdown of your account.

Trailing stops are designed to protect your profit. Once the trade has trended strongly in the expected direction, you can follow the trend by moving your stop. You could also decide to extract money from the position if the option hits your profit target. I only use profit targets for option and warrant trades, not for share trades. Profit targets tend to cap available profits. Learn to protect your profits as well as protecting your initial capital and you will be well on the way to trading effectively.

You may also need to consider a time stop if the instrument doesn’t co-operate in your allotted time frame. Try not to be too trigger happy when exiting based on a time stop for a share. The markets distribute money from the impatient to the patient. Give your trade a chance to co-operate before exiting.

Be aware that if the market is dropping like a stone, it may gap past your stop loss level. If that happens to you, just exit anyway, even if your loss was greater than initially anticipated.

I’ve been exactly where you are now – filled with hope and determination, but unsure about the best way to become an exceptional trader. I can tell you one thing – until I committed to my own trading education, I was stuck. I just couldn’t generate the trading results I felt I deserved. However, with the right techniques, you can break free.

I’m serious about helping you reach your own personal trading goals. If you genuinely want to become an ultra-versatile trader and develop an incredible lifestyle, you need a trading plan. If you’re ready to put one together, just go to my website www.tradingsecrets.com.au, register your details, and as a gift, I’ll email you my very own ‘Trading Plan Template’ straight away. It will help you work through all of the vital issues that need to be included in a sophisticated trading plan to give you an edge in the sharemarket.

In the next article, I’ll be covering the specific methods that you can use to set a stop loss. So, stay tuned, because the best is yet to come.

Louise Bedford
for Money Morning Australia

11 Comments

  1. Pete says:

    Nice Ad! :)

    I agree though, stop losses ‘can’ be useful. It does depend very much on your trading strategy though. Long-term traders probably won’t adopt this.

    Also in a volatile market, setting a touchy stop-loss might have you making more trades than you need to. Thats where the brokers win (with fees).

  2. Pete..I wonder if they could get a few more plugs into that article? :)

  3. David says:

    great ‘article’…

  4. Michelle says:

    The long term traders who haven’t adopted this may never get their money back. Lots of them have suffered 40% losses and more, and may never recover financially or emotionally, as they’ll have to make nearly 100% on their remaining equity to just get back to break even.

    I think Louise brings up some really important issues. Looking forward to the next one.

  5. Coffee Addict says:

    I agree with the article.

    I began buying at “low” prices around May 2008. Post Lehman bankruptcy events then snipped about 45% of my portfolio. As an investor (rather than a trader) I then bought more of the same stocks. While this recovery strategy largely worked for me it is always better to aviod high losses in the first place.

    Currently there are penny stock juniors that fluctuate $30 – 50% in a day. There are forced sellers who drive prices down with $1000 trades BUT occasionally medium to large investors want in. When this happens can go up 50% or so. Don’t invest in them if they are not sitting on a good resource base. If there is underlying value it may be appropriate to place simultaneous buy (at a low price) sell (at a high price) orders. Not for the faint of heart or for those who lack patience but I may give it a go.

    One note of caution – if there is a second rout – expect both long term investors and traders to act much more quickly than the did post Lehman. Once burned twice shy. As in 87, automatic trading strategies could floor the market very very quickly – so keep some trading cash in reserve.

  6. Pete says:

    Michelle: You are right…but long-term traders probably wouldn’t agree with you ;)

    I’ve spoken to many ‘long term traders’ who are of the opinion that everything recovers in cycles. Yes, they are probably fools regurgitating the ideas of even more foolish advisors. But I stand behind my claim that long term traders would probably ignore stop-loss.

  7. Pete says:

    CA: Good points. Having trading cash is reserve is excellent to make some bargain buys with oversold stock. But only for the next rally in my opinion. Longer term I think the majority will find lower lows.

    With a few standouts of course ;)

  8. Fred says:

    OK miss stop expert, nice plug, yes stops are good but cut to the chase, tell the world how you might select where to place your 1st stop loss relative to your buy price? And how might that relate to the number of shares you’d buy and your trading capital?

  9. Pete says:

    DR Admin: This topic should not be in the ‘Real Estate’ category. It belongs in ‘Market’

  10. Jean Asse says:

    Hello Miss Louise :

    As per your request, i am a newby who wants to get on board but a little sceptic based on the direction of today’s market. i am right now at the stage of paper trading . i will be soon in and i want to be good on it. i guess only technical analysis as they said can help me out . it is part of my dream to become a trader to be in to be in a position to manage risk not to avoid them as you did say.
    the topic that i want to better understand is “stop loss”

    thanks in advance for your support in term of guiding to find the best documentations and tools that can help me to tailoring my own strategy in term of “stop loss”.

    May GOD bless you !

    Regards,

    Jean Asse

  11. gwizz says:

    I wish my super funds managers did this before I lost 25% from each fund

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