To limit your risk on a trade, you need an exit plan. And when a trade goes against you, a stop loss order is a crucial part of that plan. A stop loss is an offsetting order that exits your trade once a certain price level is reached.
Here's an example. If you buy a stock at $20 and place a stop-loss order at $19.50, your stop-loss order will execute when the price reaches $19.50, thereby preventing further loss. If the price never dips down to $19.50, then your stop-loss order won't execute.
- A stop-loss order helps you limit your risk on a trade. It's an offsetting order that exits your trade when a certain price level is reached.
- Another type of stop-loss is a stop-loss limit order, which will close your trade only at the stop loss price or better.
- Your stop-loss levels should be a strategic choice based on testing out and practicing multiple methods.
Stop-loss orders are usually "market orders," which means it will take whatever price is available once the price has reached $19.50 (when either the bid, ask, or last price touches $19.50). If no one is willing to take the shares off your hands at that price, you could end up with a worse price than expected. This is called slippage. However, as long as you are trading stocks, currencies, or futures contracts with high volume, slippage isn't usually an issue.
Another stop loss order type is the stop loss limit order.
When the price of an asset reaches your stop loss price, a limit order is automatically sent by your broker to close the position at the stop loss price or a better price. Unlike the stop loss market order, which will close the trade at any price, the stop loss limit order will close it only at the stop loss price or better. This eliminates the slippage problem (which, again, isn't really a problem most of the time) but creates a bigger one: It doesn't get you out of the trade when the price is moving aggressively against you.
If you went long on a stock at $50 and placed a stop loss limit order at $49.90, and the price moved to $49.88, with no one willing to buy your shares at $49.90, you need to hope someone now fills your limit order at $49.90. If the price keeps dropping without your order being filled, your loss continues to grow.
Where to Place a Stop-Loss Order When Buying
A stop-loss order shouldn't be placed at a random level. The ideal place for a stop-loss allows for some fluctuation but gets you out of your position if the price turns against you.
One of the simplest methods for placing a stop-loss order when buying is to put it below a "swing low." A swing low occurs when the price falls and then bounces. It shows the price found support at that level. You want to trade in the direction of the trend. As you buy, the swing lows should be moving up.
Where to Place a Stop-Loss Order When Short Selling
Just like when you're buying a stock, a stop-loss order on a short sell shouldn't be placed at a random level. You want to give the market that same wiggle room for fluctuation, while still protecting yourself from loss.
With short selling, as opposed to buying, a common stop-loss order falls just above a "swing high." Like a swing low finding support at a bottom price level, a swing high finds resistance at an upper price level. This occurs when the price rises and then falls. You want to trade in the direction of the trend. When looking for short trades, the swing highs should be moving down.
Alternative Points to Place a Stop-Loss Order
These aren't hard and fast rules—you don't have to place a stop-loss order above a swing high when shorting, nor do you have to place it below a swing low when buying. Depending on your entry price and strategy, you may opt to place your stop loss at an alternative spot on the price chart.
If using technical indicators, the indicator itself can be used as a stop-loss level. If an indicator provided you with a buy signal (or a "go long" signal), a stop-loss order can be placed at a price level where the indicator will no longer signal it's wise to be long.
Volatility is another common tool for traders setting stop-loss levels. An indicator such as Average True Range gives traders an idea of how much the price typically moves over time. Traders can set a stop-loss based on volatility by attempting to place a stop-loss outside of the normal fluctuations. This can be done without an indicator by measuring the typical price movements on a given day yourself, and then setting stop-losses and profit targets based on your observations.
Define Your Stop-Loss Strategy
Stop-loss levels shouldn't be placed at random locations. Where you place a stop-loss is a strategic choice that should be based on testing out and practicing multiple methods. Find out for yourself which strategy works best for you.
Establish a trading plan by defining how you will enter trades, how you will control risk, and how you will exit profitable trades. Isolating the trend direction and controlling risk on trades is of paramount concern when learning how to day trade. When starting, keep trading simple. Trade in the overall trending direction, and use a simple stop-loss strategy that allows for the price to move in your favor, but cuts your loss quickly if the price moves against you.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.