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.
- Stop-loss orders act as an alarm when trading stocks, pulling the plug when you're wrong about the anticipated direction of the market.
- Stop-loss orders can be effective when they’re calculated and placed correctly. They'll exit when a stock has fallen below your acceptable threshold.
- You can calculate stop-loss based on the cents or ticks or pips you have at risk, or on the amount of dollars at risk.
- The same stop-loss order won’t work for all trades. They’re highly individualized but can be worth doing the math.
Correctly Placing a Stop-Loss
A good stop-loss strategy involves placing your stop-loss at a location where, if hit, you would know that you were wrong about the direction of the market. You probably won't have the luck of perfectly timing all your trades. As much as you'd like it to, the price won't always shoot up right after you buy a stock. Therefore, when you buy, give the trade a bit of room to move before it starts to go up. Instead of trying to prevent any loss, a stop-loss is intended to exit a position if the price drops so much that you obviously had 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 (a "swing 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 that low, you may be wrong about the market direction, and you'll know that it's time to exit the trade. It can help to study charts and look for visual cues, as well as crunching the numbers to look at hard data.
As a general guideline, when you are short-selling, place a stop-loss above a recent price bar high (a "swing high"). Which price bar you select to place your stop-loss above will vary by strategy, just like stop-loss orders for buys, but this gives you a logical stop-loss location, because the price dropped off that high. Studying charts to look for the swing high is similar to looking for the swing low.
Calculating Your Placement
Your stop-loss placement can be calculated in two different ways: cents or ticks or pips at risk, and account-dollars at risk. The strategy that emphasizes account-dollars at risk provides much more important information, because it lets you know how much of your account you have risked on the trade.
It's also important to take note of the cents or pips or ticks at risk, but it 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 - 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 figure helps if you want to let someone know where your orders are, or to 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 risked on the trade, though.
To calculate how many dollars of your account you have at risk, you need to know the cents or ticks or pips at risk, and also your position size. In the stock example, you have $0.06 of risk per share. Let's say you have a position size of 1,000 shares. That makes your total risk on the trade $0.06 x 1,000 shares, or $60 (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 X Pip value X position size
6 pips at risk X $1 per pip X 5 mini lots = $30 risk (plus commission)
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 1,254.25 and a place a stop-loss at 1,253, you are risking 5 ticks, and each tick is worth $12.50. If you buy three contracts, you would calculate your dollar risk as follows:
5 ticks X $12.50 per tick X 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% of your account balance, and ideally below 1%.
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%, that means they have risked 1/100 of their account. Therefore, how big should their account be if they are 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 their account to keep the risk to the 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, or $50 per trade. If you have an account balance of $30,000, you can risk up to $300 per trade (though you may opt to risk even less than that).
The Bottom Line
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 or pips or 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 incorrectly predicted the direction of the market. You need to know your cents or ticks or pips at risk on each trade, because that allows you to calculate your dollars at risk, which is a much more important calculation, and one that guides your future trades. Your dollars at risk on each trade should ideally be kept to 1% or less of your trading capital so that a loss—even a string of losses—won't greatly deplete your trading account.