In last week’s blog post, we covered the importance of having a stop loss on your trades. If you didn’t read the post or do not want to, I will summarize the main point here:
Having a stop loss will protect you from unnecessary losses and make it easier to detach your emotions from trading.
This post is targeted towards an example of how you can calculate your stop loss, places you can set it, and also where you should not set a stop loss.
How To Calculate (Personal Preference)
An effective way to calculate your stop loss is by using the average true range of whatever stock or currency you are trading.
Average true range, or ATR, is the average of how much a a stock or currency moves over a certain period of time.
Simply put, it measures the volatility.
This gives you an idea of how much you can expect a stock or currency to move, which can be effective in determining your stop loss.
You can pick any period of time you’d like for ATR, such as 10 days, 30 days, etc.
For the example, we’ll choose ATR 30. This means you would take the range of every bar over the last 30 days and divide that number by 30, to get the ATR over the last 30 trading days.
This term can be difficult to grasp through writing, so I recommend watching a couple videos on how to use and calculate ATR.
Once you have the average true range for the selected period of time (10, 14, 21, 30 days), you can multiply that number by 3–6.
This gives you a much wider stop loss than the ATR itself, which increases your chances of getting stopped out of a trade prematurely.
Where To Set Your Stop Loss
When analyzing a chart, you also want to take key areas of support and resistance into consideration.
By placing your stop below a strong area of support, you are increasing your chances of keeping your position in play without getting stopped out early.
Support and resistance play a major factor in trading and price action, so use it to your advantage.
Examples of support and resistance include round numbers, moving averages, and previous areas of support and resistance on the charts.
Where Not To Place Stops
This is important. Many traders place really tight stops, meaning that their stop loss is only 10–50 pips or points away from their entry point.
The market doesn’t move in a straight line.
There are periodic pullbacks which can cause your profits to diminish momentarily. Having a tight stop will cause your trades to consistently get stopped out quickly.
Many traders find that right after getting stopped out, price then continues in the direction they were favoring.
As a trader, you want to place wider stops to allow for pullbacks and breather periods in the market, so that your trade can continue to profit for longer periods of time.
It is easy to give up when you place tight stops because always getting stopped out will make you feel like you aren’t capable of achieving trading success.