Preventing Trading Disasters With Stop Losses
A stop loss is simply the price at which you instruct your broker to sell a trading instrument if it heads in the wrong direction. With most spread trading accounts you can set up a guaranteed stop loss automatically, which means that even if the market ‘gaps’ you will not lose more than the amount determined by the stop loss.
How to Use and How Not to
A stop loss remains one of the best ways to protect your trading account against sudden and unexpected movements in the price of a trading instrument. Strangely enough though, stop losses are also one of the most common causes of traders losing money.
The reason for this is quite simple, nobody likes to lose money, but if your fear of losing becomes so intense that you set your stop losses extremely narrow, you will not give the market sufficient chance to ‘breathe’; in other words to go about its normal ups and downs before heading in a certain direction.
If you combine this with cashing-in on winning trades too soon, you will make numerous small losses, a few wins and you will end up with a net loss on your trading activities.
On the other hand, if you set it too wide you can lose a substantial part of your trading account on a single trade. If you trade on margin, e.g. with currency trading, where you often trade with a leverage of 100:1, the situation is even more complicated. With an ordinary share trading account through a broker you can set your stop loss at 5% and be sure you will never lose more than that on a single trade. With a currency trade leveraged at 100:1 you will lose your whole investment if you set the stop loss at 1%.
Your stop loss level should be determined by your risk appetite and the time frame in which you trade. Long-term traders can expect large profits in the long run, so they have to be willing to stomach wider stop losses. Day traders, that is, those who use leveraged spread trading accounts, should use much narrower stop losses.
Trailing Stop Loss
A stop loss is not only useful for limiting losses, it can also be used to ‘lock in’ profits. A trailing stop loss is a stop loss ‘locked’ at a certain percentage below the price, whatever it is at any given moment. This means that when the price of a trading instrument goes up it ‘drags’ the trailing stop loss with it and the moment the price drops by the given amount the transaction is closed.
Average True Range
Our favourite way to calculate a stop loss level is to use the ATR or Average True Range, which was first described by J. Welles Wilder in his 1978 book ‘New Concepts in Technical Trading Systems’. This is a simple indicator available in most charting packages, which calculates the level of volatility in the price of a trading instrument at any given moment.
The best way to use this to determine your stop loss level is simply to deduct a multiple of the ATR from the current price of the commodity.
Fig. 11.18(a) is a daily chart of the Gold price and a 14-day ATR of the price below that. If you decide to enter the market at point A, you would simply find the corresponding ATR by looking at the ATR chart directly below that price.
In this case it would mean setting your stop loss 29.65 below the current price or multiples of that amount, depending on your timeframe and risk appetite.