How To Calculate the Size of a Stop Loss When Trading
How and where to place a stop loss order
Day traders should always use a stop loss order on their trades. Barring slippage, the stop loss lets you know how much you stand to lose on a given trade. Since you will be using a stop loss as a day trader, the next step is learning how to calculate your stop loss, and determining where your stop loss order will go.
Correctly Placing a Stop Loss
Place a stop loss at a location, where if hit, lets you know you are wrong about the direction of the market.
It is unlikely you will have exact timing on all your trades, for example buying right before the price shoots up. Therefore, when you buy, you need to give the trade a bit of room to move before it starts to go up. But, if you are buying you are expecting the price to go higher, so if it starts to drop too much it should hit your stop loss because you were wrong in your expectation.
As a general guideline, when you are buying, place a stop loss below a recent price bar low. Which price bar you select to place your stop loss below will vary by strategy, but this is a logical stop loss location because the price bounced off that low. If the price moves below the low again you may be wrong about the price going up, and therefore it is 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 is 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 the trade. Figure 2 (click to open) shows examples of this tactic.
Calculating a Stop Loss
Your stop loss can be calculated in two different way: cents/ticks/pips at risk, and account-dollars at risk. Account-dollars at risk is a much more important calculation because that lets you know how much of your account is at risk on the trade.
Cents/pips/ticks at risk is also important but is more relevant for simply relaying information. For example, my stop is at X and long entry is Y, so the difference is 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 you own).
If short the EUR/USD forex pair at 1.1569, and have a stop loss at 1.1575, you have 6 pips at risk (per lot).
This is useful if you are just letting someone know where your orders are, or letting 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 are risking 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, there is $0.06 of risk per share. If your position size is 1000 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, your dollar risk is calculated as: pips at risk X pip value X position size = 6 x $1 x 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 we will use 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, your dollar risk is: 5 ticks X $12.50 X 3 contracts = $187.50 (plus commissions).
Control Your Account Risk
To take this a step further, the amount of dollars you are risking should only be a small portion of your account. Typically, the amount we are risking should be below 2% of our account balance, and ideally below 1%.
Take the example or our forex trader, using a 6 pip stop loss and trading 5 mini lots, which results in a risk of $30 for the trade. If risking 1%, that means she is risking 1/100 of her account. Therefore, how big should her account be if she is willing to risk $30 on a trade? $30 x 100 = $3000. To risk $30 on the trade, the trader should have at least $3000 in their account to keep the risk to the account very low.
Quickly work the other way to see how much you can risk per trade. If you have a $5000 account you can risk $5000 / 100 = $50 per trade. If your account is $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 your strategy determines where the stop loss is placed. Depending on the strategy, your cents/ticks/pips at risk may be different on each trade. That's because the stop loss should be placed strategically for each trade--it should only be hit if you are wrong 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. Your dollars at risk on each trade should ideally be kept to 1% or less of your trading capital. That way, even a string of losses won't greatly deplete your trading account.
Updated by Cory Mitchell.