How to Calculate Stop Loss
As a day trader, you should always use a stop loss order on your trades. Barring slippage, the stop loss lets you know how much you stand to lose on a given trade. Once you start using stop-loss orders, you'll need to learn how to calculate your stop loss and determine exactly where your stop loss order will go.
Correctly Placing a Stop Loss
A good stop-loss strategy involves placing your stop loss at a location, where if hit, will let you know you were wrong about the direction of the market. You won't likely have the luck of exact timing on all your trades, such as buying right before the price shoots up.
Therefore, when you buy, give the trade a bit of room to move before it starts to go up. However, if you have chosen to buy a stock, you are expecting the price to go higher, so if the stock starts to drop too much it will hit your stop loss because you set the wrong expectation about the market's direction.
As a general guideline, when you buy stock, place your stop loss price below a recent price bar low. Which price bar you select to place your stop loss below will vary by strategy, but this makes a logical stop loss location because the price bounced off that low point. If the price moves below the low again, you may be wrong about the price going up, and you'll know it's time to exit the trade. Figure 1 (click to open) shows examples of this tactic.
As a general guideline, when you are short selling, place a stop loss above a recent price bar high. Which price bar you select to place your stop loss above will vary by strategy, but this gives you a logical stop-loss location because the price dropped off that high.
If the price moves above that high again you may be wrong about the price going down, and therefore it is time to exit your trade. Figure 2 (click to open) shows examples of this tactic.
Calculating Your Placement
Your stop loss placement can be calculated in two different ways: cents/ticks/pips at risk, and account-dollars at risk. Account-dollars at risk provides much more important information because it lets you know how much of your account you have at risk on the trade.
Cents/pips/ticks at risk is also important but works better for simply relaying information. For example, your stop is at X and long entry is Y, so you would calculate the difference as follows:
Y minus X = cents/ticks/pips at risk
If you buy a stock at $10.05 and place a stop loss at $9.99, then you have six cents at risk, per share that you own. If you short the EUR/USD forex currency pair at 1.1569 and have a stop loss at 1.1575, you have 6 pips at risk, per lot.
This helps if you just want to let someone know where your orders are, or let them know how far your stop loss is from your entry price. It does not tell you (or someone else) how much of your account you have at risk on the trade, though.
To calculate how many dollars of your account you have at risk, you need to know the cents/ticks/pips at risk, and also your position size. In the stock example, you have $0.06 of risk per share.
If you have a position size of 1,000 shares, then you are risking $0.06 x 1000 shares = $60 on the trade (plus commissions). For the EUR/USD example, you are risking 6 pips, and if you have a 5 mini lot position, calculate your dollar risk as:
Pips at risk * Pip value * position size = 6 * $1 * 5 = $30 (plus commission, if applicable)
Your dollar risk in a futures position is calculated the same as a forex trade, except instead of pip value you would use a tick value. If you buy the Emini S&P 500 (ES) at 1254.25 and a place a stop loss at 1253, you are risking 5 ticks, and each tick is worth $12.50. If you buy 3 contracts, you would calculate your dollar risk as follows:
5 ticks * $12.50 * 3 contracts = $187.50 (plus commissions)
Control Your Account Risk
The number of dollars you have at risk should represent only a small portion of your total trading account. Typically, the amount you risk should be below 2 percent of your account balance, and ideally below 1 percent.
For example, say a forex trader places a 6-pip stop loss order and trades 5 mini lots, which results in a risk of $30 for the trade. If risking 1 percent, that means she has risked 1/100 of her account. Therefore, how big should her account be if she is willing to risk $30 on a trade? You would calculate this as $30 x 100 = $3,000. To risk $30 on the trade, the trader should have at least $3,000 in her account to keep the risk to her account at a minimum.
Quickly work the other way to see how much you can risk per trade. If you have a $5,000 account you can risk $5,000 / 100 = $50 per trade. If you have an account balance of $30,000, you can risk up to $300 per trade but may opt to risk even less than that.
Final Word on Calculating a Stop Loss
Always use a stop loss, and examine your strategy to determine the appropriate placement for your stop-loss order. Depending on the strategy, your cents/pips/ticks at risk may be different on each trade. That's because the stop loss should be placed strategically for each trade.
The stop loss should only be hit if you predicted incorrectly about the direction of the market. You need to know your cents/ticks/pips at risk on each trade because this allows you to calculate your dollars at risk, which is a much more important calculation and guides your future trades. Your dollars at risk on each trade should ideally be kept to 1 percent or less of your trading capital so that even a string of losses won't greatly deplete your trading account.