It’s a question that’s impossible to answer as it depends on several things – and each trade is different, as many things affect a particular instrument you’re trading. [An instrument is a stock (aka equity), commodity, forex, or whatever]. The really big and most important point of a stop-loss is to limit losses and limit risk.
Being stopped-out and price fluctuaton:
One of the biggest mistakes new traders make – and I still get this wrong on occasion – is setting too tight a stop-loss. When I was quite green, I’d make quite tight stops as my ‘common sense’ at that time would say, ‘Don’t make the stop too large, as you could lose so much money’. This was of course the wrong thing to think, as I discovered later on. How did I come to a different understanding? I realised late in the game that if you’re trading a 4-hour time frame, price will bounce around considerably in the lower time frames. I hadn’t appreciated by how much. Even in the 4-hour time frame price will fluctuate a lot, even more than in lower time frames. The idea is to let price fluctuate sufficiently and in your calculated direction. It’s pointless getting stopped out early, then realising that the market has moved in your calculated direction – and you’ve been left behind. So, the stop-loss has to be big enough not to get you thrown out prematurely due to that ‘natural’ bouncing around – but also good enough to manage your ‘acceptable’ loss, if price moves against you.
Preparing to lose but limiting losses (that’s the name of the game)
When you’re about to enter a trade, you have to consider how much you are prepared to lose – that’s really the very first big issue. So how much should you prepare to lose? A very sound and well tested figure – is about 1 – 3% of the equity in your account. So if on a demo account you have £20,500, then you must be prepared to lose between £205 and £615. I’d usually say stick closer to 1% – and be very mindful of ‘The Enemies’.
If you know that you’re prepared to lose say £200, then you decide how many points the instrument would fall to equate to £200. So if you decide to bet £0.5, then you can only sustain a 400pt movement of price against you. But is 400pts (in that scenario) correct. How do you know that price may not fall 800pts.
Several things should be considered:
- Some large instruments like Google, Amazon and Netflix will fluctuate hundreds of points in a day. So you realise that 400pts is likely to fail early. What do you do? Simple – don’t trade those.
- What’s the average size of candles in the particular instrument. If 50% of them, say, are larger than 400pts, well you know that you’re more than likely to lose.
- Size of candles and range of price fluctuations vary by the time frame you’re thinking of trading. On weekly charts you can expect larger fluctuations in points/per candle.
- Size of target and reasonable reward to risk ratio’s may also affect your stop loss to some extent – sometimes unconsciously. There is a risk that you tighten the stop-loss to make the RR ratio look good.
- Is the identified entry point actually the best – and how did you arrive at that conclusion?
- To help with some of the above, the Average True Range (ATR) of the instrument, on the particular time-frame, gives a reasonable estimate of the volatility of price. ATRs are calculated automatically on most charting systems and presented on a graph (there is no real need to understand all the mathematics that goes into the ATR calculation, as that understanding adds nothing). In general, your stop-loss should be about 2 x ATR figure (this can be varied of course, but from experience less than 1 x ATR leads to early stopping-out). So if you see an ATR figure that tells you that the stop-loss should be around 800pts and you’re limited by the 1% rule above to 400pts for your bet-size, you simply do not take the trade. Move on – do not become attached to the instrument, as if it is a stock you own. You own nothing in spreadbetting – except your cash. Find another instrument that is within your range. For more on this see Informed Trades video.
Do you change your stop-loss?
This should first be answered in terms of when not to change the stop-loss. It’s unwise to move stops to accommodate the market if price is moving against you and closer to your stop-loss. Why? Because you’re increasing your risk beyond what you were originally prepared to lose. In some situations you can do that, but I’d never recommend moving stops a great distance so as to take on 10, 25 or 30% more risk. The whole point of the stop-loss is to limit losses. You’ll lose 60-70% of all trades anyway – even the experts do. That’s a lot. So the problem of moving stops is a serious consideration for that large body of risk in total. It can eat into profits or work against a break-even from your 40% (big) winning trades – and ultimately lead to overall losses. [Example for 10 trades: 4 x 300 = £1200 (winnings). 6 x (-)200 = £(-)1200 (losses) i.e. just breaking even. So increasing your stop-losses by 10% leads to an overall loss. Of course that’s a constructed example to show how the chips are stacked against you. But even with more favourable winnings on 40% of trades there could be a tendency to increase stop-losses, leading to heavier losses, which then erode the big winnings.]
It is wise to move a stop-loss in your favour as price moves in your favour. How much is another big consideration and there is no easy answer. Considerations will be:
- How much has price moved in your favour? Has price neared your target? Has price exceeded your target?
- Can you set up trailing stop? If so, how close do you trail the price? There are different ways deciding that. Some people use a 21 Exponential Moving Average (found on Tradingview) to assist. Others decide to move stops manually on every 5 candles moved in favour. [It’s difficult to explain all that in text form, and this is where self-driven learning and experience must come in].
This was not meant to be a tutorial – so I expect it will leave much unexplained. Diligent new traders are expected to undertake some self-directed learning. Google and Youtube are your friends to assist – and there’s no substitute for trying out charts and making a few mistakes on a demo account.