Stop loss orders (also known as stop losses or stops) are used to exit a trade if the trade starts to lose money (i.e. if the market moves against the trade). These are one of many tools a trader can use to add some downside protection to a portfolio.
With all order types, there are pros and cons. For a stop order, it will execute into a market order once the stock price reaches the stop order amount. At this point, this guarantees execution but not a specific price. A common misconception is the stop order price "protects" the stock from selling below this amount. A stop limit order would offer this protection by executing a limit order but gives up the guaranteed execution.
Stop loss orders are used both as regular exits and as emergency exits (i.e. a crash stop), but the following suggestions are based upon using a stop loss order as a regular exit.
Correctly Placing a Stop Loss Order
There are two different methods for correctly placing stop loss orders. One method is more suitable for discretionary traders, while the other method is more suitable for system traders. Therefore, the method that you use to place your stop loss orders should be based on the type of trader that you are. If you do not yet know which type of trader you are, please figure that out first.
The discretionary trading method is to place your stop loss order at a price at which you do not expect the market to trade. In other words, you would place your stop loss order at a price, which if traded at, would change your opinion of the direction of the market. The idea behind this method of placing a stop loss order is that if the market reached your stop loss price, you would no longer want to be in your trade, so the stop loss would exit your trade for you.
The system trading method is to place your stop loss order based upon your trading system's risk to reward and win to loss ratios. In other words, if your trading system's risk to reward and win to loss ratios indicate that the optimal stop loss distance is 10 ticks behind your entry price, then your stop loss order should be placed 10 ticks behind your entry price. This method is based on mathematical calculations, and there is no discretion involved in the decision of where to place your stop loss order.
There is an alternative version of the system trading method of placing a stop loss order that uses indicators. If during testing of your trading system you determined that a particular indicator pattern provided the optimal trade exit, you would place your stop loss order based upon the indicator pattern instead of the risk to reward and win to loss ratios.
Incorrectly Placing a Stop Loss Order
There are many ways to incorrectly place a stop loss order (and traders probably make up new ones every day), however, some ways are more commonly used than others.
Percentage-based stop loss orders are stops that are placed a fixed percentage behind the entry price. For example, if a long trade is entered at 1,250, a 2% stop loss would be placed at 1,225 (25 points lower than the entry price). The percentage that is used might be based upon the entry price, the value of the trade (i.e. the price multiplied by the number of shares), or the target of the trade. Regardless of which calculation is used, percentage-based stop loss orders are not based upon market dynamics in any way, so it is not surprising that they are not an effective method of placing stop loss orders.
Random price stop loss orders are stops that are placed at an arbitrary price. Random price stop loss orders are sometimes used in an attempt to place stop loss orders at less obvious prices. However, humans are not effective at choosing random numbers, so these supposedly random numbers are often not random at all (such as a trader who unknowingly always chooses round numbers). As with percentage-based stops, random price stops are not based upon market dynamics. In addition, random price stop loss orders cannot be tested, so there is no way of knowing if they are being placed at a profitable price or not.
How to Place Your Stop Loss Orders
If you are a discretionary trader, you need to think about why you are placing your stop loss order at a particular price, and if you do not know why then it is not a good stop loss. Discretionary stop loss orders need to be based upon market dynamics, otherwise, they will not be effective in protecting your trading capital (which is the point of a stop loss order).
If you are a system trader, you need to have test results that identify exactly where your stop loss orders should be placed, and then follow the results exactly. If you either do not have test results, or you are not following the results, then you are adding unnecessary risk into your trading, which is the opposite of what a stop loss should be doing.