Stop losses

Stop losses are the same as a stop limit order, in terms of online trading, stop losses are a price you set at which your shares will sell automatically. Stop losses greatly reduce the risk involved in trading shares. Whenever you buy (go long) or sell (short)  a share, brokerage accounts allow you attach stop losses for free to a share.

The standard stop loss

Is simply a price you set at which the share will automatically be sold.

Stop Loss Example 1

• you buy a share on an up trend @ $20.00
• you put a stop loss in @ $19.75
• the price could go down to $19.75 and your shares will be sold automatically
• meaning you will only ever lose 1.25% of your investment ((100/20)x19.75)
• however, if the stock went up you would set to gain a lot more than 1.25%!

Stop Loss Example 2

Helmerich & Payne Inc | January 2007 – August 2007

• the share hits the resistance line four times at points 1,2,3 and 4.
• you buy the share at point 5 when it move above the resistance line
• and put you stop loss at point 6 to sell the share at $28.53 (risking a loss of around 1%)
• however as the chart shows, it was possible to gain almost 25%!

Lets put that in monetary terms

• you buy 130 shares at $28.90 (point 5) = $3,757
• you risk around 1% = $37 [its important to note you will often lose this 1%]
• however in this example you could gain up to 25% = $939!!
• meaning that you could lose a lot more trades than win and still make money!

Stop Loss Example 3

Example 3 is going to show how stop losses work for shorting stock as well as buying.

Pulte Homes | June 2006 – April 2007

• the share hits the resistance line two times a points 1 and 2
• you sell the share when it breaks the resistance line at point 3.
• and put the stop loss at point 4 to buy back the share if it hits $30.50 (risking about 1.1%)
• however as this chart shows you could set to gain around 15%!

In monetary terms

• you sell 400 shares at $30.19 (point 3) = $12,076
• you risk around 1.1% = $120 [again, its important to note you will often lose this 1%]
• however in this example you could gain up to 15% = $1,811!!

Percentage stop losses

Percentage stop losses are similar to standard stop losses, they both have set at a fixed price at which the share sells. However the difference is in the way you set them. Standard stop losses you choose a number e.g. 19.75, but with percentage stop losses you choose a percentage of your trade you are willing to lose.

Example

• You buy 100 shares @ $20 = a $2000 investment
• You set the stop loss @ 3%
• The stop loss will be triggered if the share price reaches $19.40
• and the maximum you will lose is $60 (3%)

Trailing stop losses

Guess what, it gets better! There’s not just two kinds of stop losses, there’s another called a trailing stop loss. This type of stop loss follows the last price (current price) by a percentage or a numeric monetary value set by you.

Examples (based on a 3% trailing stop loss)

• If you set a 3% stop loss then and your stock drops 3% then it is automatically sold
• If your stock drops 2.5%, goes up 1% then back down by 1.5% then it is automatically sold
• If your stock rises 8% and then drops 3% then your stock is sold at a 5% profit.
• If your stock rises 9% then the minimum you take away is 6% profit etc.
• If your stock rises to 7% then your stop loss will stay at 4% until the stock rises over 7%, regardless of how much movement has taken place between the 4.01% and 7% profit levels.

The trailing stop loss is a great way to lock in your profit whilst still cutting any losses short. The disadvantage of a trailing stop loss is that if a stock’s price is erratic and your stop loss % is small then you are likely to be cut out of a trade.

Improving the psychology of trading

It is important to note that stop losses are important for the psychology aspect of trading as you have a set price to dispose of the share. By setting a stop loss, you avoid the situation of “I’m going to get rid of it in a minute as soon as it makes a bit of money back that i’ve lost ” and then lose even more! This is a classic thought process that goes through a traders head and by setting stop losses, the chance of this thought process is eradicated.