My Advice for Choosing the Right Stop Loss

Occasionally readers ask what I recommend regarding stop losses. So I wanted to share my answer.

Stop loss orders give me peace of mind. What would you recommend on that? A percent trailing stop maybe? Feedback would be highly appreciated.

– Sherif S.

Setting stop losses is key to managing risk in the markets.

Without a stop loss, you don’t have a clear and concise way of knowing when to cut a position.

So many people without stop losses often end up cutting a position based on pure emotion… typically, when they can no longer bear the pain.

And that ends up costing them a lot of money.

But when it comes to setting stop losses, it’s not always easy to know exactly where to place them…

Stops in a Volatile Market

Some investors stick with a simple fixed stop loss – a fixed percentage or dollar amount below the stock’s price.

But the rigidity of a fixed stop can be rough in different market conditions… like when a stock becomes volatile and starts swinging unpredictably.

However, one helpful method that offers a more nuanced solution uses the Average True Range (ATR).

The ATR calculates the average range of a stock or index over the preceding 14 days (though some might use a longer time frame).

So if volatility is steadily increasing, then so will the ATR (and vice versa). It’s useful because it reflects the current volatility of that stock or index.

Stocks typically fall more dramatically than they rise. So the ATR usually increases during pullbacks.

Just take a look at the SPDR Dow Jones Industrial Average ETF Trust (DIA) chart below…

When DIA’s stock price rose from ‘A’ to ‘B,’ the ATR fell from $5.59 to around $2.52… And when DIA fell from ‘B’ to ‘C,’ the ATR climbed from around $2.52 back up to $4.06.

While they’re not an exact mirror image, you can see an inverse relationship between the ATR and DIA’s stock price.

To give a stock enough room to move, typically an ATR-based stop is set as a multiple of the ATR… often three, four, or five times.

For example, if the ATR is $5 and a stock is trading at $100, a trader using a multiple of three times ATR will have a stop loss at $85 – or $15 below the stock price.

Remember, the goal is to capture as much of a move as possible. A stop protects traders from a move in the opposite direction – without being stopped out unnecessarily.

If we set our stop too tight (too close to the current price action), we run the risk of getting stopped out prematurely. That means we could be giving up profits.

So how do you apply it?

Using ATR With Trades

How you use an ATR depends on your time frame.

For instance, a short-term trader who wants to capture lots of little profits (without risking too much) might use a lower multiple like two or three.

So if the ATR in our DIA example is $5, then you might only allow the stock price to fall $10 (using an ATR multiple of two) before you’re stopped out.

However, a long-term trader – who wants to capture a move that may last for months or years – might use a much higher multiple (five or six).

It should be enough to capture the full potential of an up move without getting stopped out by a quick pullback.

The key is to look at the price chart and work out what multiple suits your goal from the trade.

Like anything in the markets, it’s not a perfect solution. Yet it certainly helps put the odds in your favor.

Using an ATR as part of a stop-loss strategy helps fine-tune your exit strategy.

Most importantly, it lets you have a defined exit point and gives the stock sufficient room to move so that you’re not stopped out prematurely.

And this way, you don’t have to rely on your emotions to figure out when to exit a position.

Regards,

Larry Benedict
Editor, Trading With Larry Benedict