No one wants to lose money when they're playing the market. That's why it's important to set a floor for your position in a security. That's where stop-loss orders come in. But many investors have a tough time determining where to set their levels. Setting them up too far away may result in big losses if the market makes a move in the opposite direction. Setting stop-losses too close, and you can get out of a position too quickly.
So how do can you tell where to set your stop-loss order? Read on to find out more.
What Is a Stop-Loss Order?
A stop-loss order is placed with a broker to sell securities when they reach a specific price. These orders help minimize the loss an investor may incur on a security position. So if you set the stop-loss order at 10% below the price at which you purchased the security, your loss will be limited to 10%.
For example, if you buy Company X's stock for $25 per share, you can enter a stop-loss order for $22.50. This will keep your loss to 10%. But if Company X's stock drops below $22.50, your shares will be sold at the current price.
Slippage refers to the point when you can't find a buyer at your limit and you end up with a lower price than expected.
Determining Stop-Loss Order
Determining stop-loss order placement is all about targeting an allowable risk threshold. This price should be strategically derived with the intention of limiting loss. For example, if a stock is purchased at $30 and the stop-loss is placed at $24, the stop-loss is limiting downside capture to 20% of the original position. If the 20% threshold is where you are comfortable, place a trailing stop-loss.
Know where you're going to place your stop before you start trading a specific security.
There are plenty of theories on stop-loss placement. Technical traders are always looking for ways to time the market, and different stop or limit orders have different uses depending on the type of timing techniques being implemented. Some theories use universal placements such as 6% trailing stops on all securities, and some theories use security or pattern-specific placements including average true range percentage stops.
Stop-Loss Placement Methods
Common methods include the percentage method described above. There's also the support method which involves hard stops at a set price. This method may be a little harder to practice. You'll need to figure out the most recent support level of the stock. As soon as you've figured that out, you can place your stop-loss order just below that level.
The other method is the moving average method. By using this way, stop-losses are placed just below a longer-term moving average price rather than shorter-term prices.
Swing traders often employ a multiple-day high/low method, in which stops are placed at the low price of a pre-determined day's trading. For example, lows may consistently be re-placed at the two-day low. More patient traders may use indicator stops based on larger trend analysis. Indicator stops are often coupled with other technical indicators such as the relative strength index (RSI).
What to Consider with Stop-Loss Orders
As an investor, there are a few things you'll want to keep in mind when it comes to stop-loss orders:
- Stop-loss orders are not for active traders.
- Stop-loss orders don't work well for large blocks of stock as you may lose more in the long run.
- Brokers charge different fees for different orders , so keep an eye out for how much you're paying.
- And never assume your stop-loss order has gone through. Always wait for the order confirmation.
- A stop-loss order is placed with a broker to sell securities when they reach a specific price.
- Figuring out where to place your stop-loss depends on your risk threshold—the price should minimize and limit your loss.
- The percentage method limits the stop-loss at a specific percentage.
- In the support method, an investor determines the most recent support level of the stock and places the stop-loss just below that level.
- The moving average method sees the stop-loss placed just below a longer-term moving average price.
The Bottom Line
Traders should evaluate their own risk tolerances to determine stop-loss placements. Specific markets or securities should be studied to understand whether retracements are common. Securities that show retracements require a more active stop-loss and re-entry strategy. Stop-losses are a form of profit capturing and risk management, but they do not guarantee profitability.