Stop loss. The bible of risk management. The maker or breaker of portfolios…….and emotions! Stop Losses are both a blessing in trading, and a curse!
Setting them and knowing where to set them can make the difference between good risk management practices and saving your portfolio, or poor placement and getting stopped out enough to chip away at your portfolio and sanity, causing enough smaller losses to trigger worse practices like revenge trading and over trading. So where do we set them? What is even a stop loss?
A stop loss can be defined as an advance order to sell an asset when it reaches a particular price point. It is used to limit loss or gain in a trade. The concept can be used for short-term as well as long-term trading. In general, if you open a trade, whether a buy order or a short order, a stop loss is a price point you set to close out your position in the event the trade goes against you and minimizes your loss.
So how do we set them? First and foremost, it is imperative you first understand and learn what support/resistance zones are and how to identify them. This is key in knowing a proper placement of a stop loss. It is also important to note that everyone has a different preference on where they feel stop losses should be placed. For my own personal rules, I tend to set them just below the support zone when margin long, or just above the resistance zone when margin short. Spot trading (non leverage) altcoin trades, given that alts can move in a 3–5% range daily with ease, I set my stop loss around 5% below my buy order. Other traders may set theirs closer at say 3% while others may stretch it to 7%. So you must establish your own rules with regards to stop loss when trading with margin or spot, and be comfortable with what you’re willing to lose if your stop is triggered.
As noted above, It is first most important understand Support/Resistance zones. In Figure 1 below, we have identified a confluence zones with the top and bottom of the zone identifying our support bottom and resistance high. Let’s note the multiple wicks reaching a relative same price point on both the resistance line and support line. Lets say we wanted to buy a long position at this support zone noted in “buy long”. We can count roughly 6 attempts to break this support line with only 1 wick below but no price candle body close below support, so we open long for a trade on the basis we feel the bulls have defended this price and will push the price up. An ideal stop loss, would be just slightly below that support zone to avoid a “stop hunt” on a flash wick. Stop hunts are notorious by market makers to liquidate/stop out traders for liquidity grabs before pushing in the direction of the original trade. So to avoid a stop hunt, ideally our stop loss would be below the multiple wick contacts on the support line. (Note .6% below our buy zone is the price movement of an asset, so take into consideration your leverage. If you are long in the support zone with a 10x leverage, and you are stopped out at that .6% marker, you incur a 6% loss on your position. (10x x .6 = 6)
So now that we’ve set our stop loss below our support zone and we walk away for a day or so in hopes our long plays out and makes us money! We log in after a day to see our trade did NOT pan out and did not break resistance to continue a pump and instead failed and dumped! We panic because price has since dropped significantly below our buy zone, but can express a sigh of relief as we remembered we had a stop loss set and saved ourselves against getting liquidated and losing our whole position, or if we were spot, losing 10% of our position shown in Figure 2. (Setting a stop loss, automatically closes the trade for you if triggered.)
Same is true in opposite trade direction, if we want to open a short position at the top of a resistance zone and open short upon confirmation of resistance failure. in Figure 3, our rules still apply. We opened a short position and set our stop loss just above the resistance top. In this scenario, lets assume we did not get stopped out of our position and our trade went in our favor and price dropped as we expected. Our stop loss is still in place, but our trade this time is in profit! Hurray!! Great Success! (Thanks Borat).
Misuse of setting a Stop Loss
There’s an emotional trainwreck of ill-proper use of stop loss. Yes, this happens quite a bit! Inexperienced traders, especially those who trade on emotions, will often set Stop losses at random price points or simply in the wrong place, just as slightly ABOVE the bottom of a support or slightly BELOW the top of a resistance without regards to price wicks. This is where a trader can get chopped up (in this example given the flat channel) and incur multiple small losses to their portfolio. See Figure 4. This trader opens a long position at the bottom of candle bodies, rather than considering stop hunts on the wicks, and repeatedly opens the same position at the same price with the same stop loss and is stopped out 4 times on the wicks. In this example, I chose a distribution pattern as this is where the majority of traders try to “guess” the market direction and make mistakes in regards to stop losses and get ‘chopped up’.
Other examples would include an array of patterns like Trendline support. In this example, a trader opens an order based on previous touches of a trendline, assuming that trendline will hold and continue in the direction of the trend. So a trader opens a position, in a support zone, in anticipation of an uptrend continuation off a trendline. A fake out dump occurs and wicks out the trader on a “stop hunt” as shown in Figure 5, and continues to pump in the direction of the trend, leaving the trader behind as he was stopped out of the trade. This is where Stop losses can also be a curse as the trader would have been in a good profitable trade had he not been stopped out. Now he is left on the sidelines, and missing profit!
For altcoins, or if using Non-leverage, stop losses can be stretched and provide a bit more cushion to avoid being stopped out of a trade. My personal preference is roughly 5% from my buy entry. In Figure 6, let’s say I bought LOOM in the support zone noted by the grey box, and noted the multiple touches on the support line with the blue arrows to confirm my bias of support. My stop loss, I would set 5% below my entry. Given how close this altcoin is to its bottom, I could choose to stretch my stop loss further all the way to the bottom of the lowest low price for an additional 2%, giving my stop loss a cushion of 7%.
How to set them in the exchange…..
Every exchange will have their own setup for placing stop orders. For this example, I am using the new derivatives exchange BitOrb. So lets say I open a long position for 10,000 contracts at 5x leverage. For this exercise, I simply clicked the given option for a 5% stop loss and the exchange automatically input the price for me at the price point in which my position will be closed out if my stop loss is triggered. If i wanted to tighten my stop loss, I could click on the pencil button out to the right of the Stop Loss slider bar (just to the right of 50%), and manually input my own desired stop loss. Easy peasy! Most exchanges will automatically calculate for you the price at which your position will be stopped out, and most will even show you the amount you would lose if your stop is triggered. In this instance, I’d lose $100.
You may also notice on some exchanges, the ability to set a “Trailing Stop”. Trailing stops also have its pros and cons. A trailing stop ‘trails’ price action by a dollar amount you set. Lets say I opened a long position at 7100 for Bitcoin, and i set my trailing stop loss at $50. So it would stop me out if price dipped down to 7050 and close out the trade. Lets assume now price climbs and lets say Bitcoin is now 7400, my ‘trailing stop’ would automatically be set $50 beneath that price at 7350. So in the event there’s a flash crash or major dump while I’m away or happens faster than I can react and manually close out my position, it automatically closes it for me and locks in my profit. So the “trailing stop” simply ‘trails’ the price of the asset, and automatically moves/adjusts your stop loss as price moves in the direction of the trend.
Of course the flip side to that is, if you have a tight trailing stop, and there’s a flash wick that would stop you out of the trade, but continues in the direction of the trend, then you are taken out of the trade and miss the rest of the trends profits. For example, you open at 7100 with a trailing stop of $50…Bitcoin pumps to $7400 which means your new stop loss is auto adjusted to 7350, and there’s a flash wick to 7340…your stop is triggered and you lock in the profit on that move, but Bitcoin then continues the trend and then pushes to 7600. You’re out of the trade and on the sidelines missing the rest of the move. Trailing stops are more of a blessing than a curse as they protect your trade in a trend from major dumps that would cost you to lose profit fast!
These are my own personal thoughts on stop loss. Please note every trader is different with different comfort levels of risk and have different preferences for placement. Stop Loss should always be considered when trading to always protect your capital and practice sound risk management.