When you open a trade, a stop loss is probably the primary exit method that you will use to realize it’s time to get out of a trade because it’s losing money. A stop loss is a weapon that you need to use to prevent a small loss from moving into a major loss. This may be your most important element in every trade, as big losses can drive an unsuccessful trading career.
Every trade should end in one of these 4 ways:
- A great victory
- A little profit
- A minor setback
No trade should result in a massive loss, or the way you eliminate the huge losses from your trades could be the inclusion of a stop loss.
A stop loss in your relative time frame should be far enough away from normal market action, however near enough to avoid what would be called a huge loss by your own standard. Your position size behaves in relation to the order book at the trigger of your stop market, of course, and you shouldn’t be selling such a large position that when your stop is activated you create slippage and pay the price.
Using price action as your compass, here are five stop loss methods:
- Exit your trade based on a main-moving average support break. Exit your trade during an uptrend when the key moving average support has been broken. Exit your short during a downtrend when the key moving average resistance has been recaptured.
- Exit your trade based on a percentage decline from your entry point. Your exit strategy may be to sell for a loss if the price falls from your entry price by more than 5 percent. If you bought it at $100 however it falls below $95 your stop loss would trigger.
- You may exit your trade based on a time stop. When you buy at $100 for a swing trade with a price target of $10 and the stock is still selling at $101 weeks later, one tactic is to exit and free up resources for better opportunities as the asset has failed to meet the profit target within a reasonable period of time. In reality, this relies on the specifications of your own program, which can vary.
- Your stop loss may be dependent on a technical signal such as RSIbreaching a critical level, the price far below the lower Bollinger band, or a MACD cross over. It is also possible to use technical indicators as tools in creating good risk/reward opportunities and establish proper exits based on risk.
- You may use a volatility stop if the market or asset is growing parabolically, or it starts moving the entire daily range against you. You either reduce the size of your position or exit because of increased risk dependent on the volatility expansion. Another way to measure this is the ATR (Average True Range).
There can be many approaches to limit the danger of the loss and let you know ahead of time your trade probably won’t work out. To keep the losses minimal, every good trading plan should have signals for entry and risk-minimizing invalidation signals as well.
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