What is a Stop Loss?
A stop loss is an order telling your broker to sell the stock if the stock price falls to a specific price level.
Why should you use stop losses?
Stop Losses protect your capital from catastrophic losses.
What is a Profit Stop Loss?
A Profit Stop is a Stop Loss that is employed as a stock is moving up in price in order to protect short-term profits. Whenever you are trading short-term, such as swing trading, momentum trading, or position trading, keeping the stop loss at a proper support level while you are holding the stock as it moves up helps protect your profits from a sudden reversal due to large-lot profit-taking.
Why You Should Never Use a Percentage Stop Loss
Percentage Stop Losses are an outdated method for determining where to place a stop loss. Percentages for trading strategies were developed in the mid-20th century for a very different market than we have today. At the time, there was no Internet, no online brokers, and most of the market was long-term investing. Since no one used stock charts or technical analysis, a percentage stop loss made sense, especially for a long-term investment.
Nowadays, the market activity is predominantly short-term trading with heavy emphasis on technical analysis as well as fundamental analysis. This means that a percentage stop loss can cause you to to be exited from a stock simply because your stop loss is in the wrong place, trailing the price of the stock by a certain percentage, which is often where heavy trading is occurring between floor traders, professionals, and High-Frequency Trading firms that use complex Quantitative Analysis algorithms to buy and sell stocks on the millisecond scale. This heavy trading activity can accidentally trigger a sell order on your stock if you use percentages.
For today’s market, it is better to use technical analysis in order to determine the proper support levels for your stop loss and profit stops based on how long you intend to hold that stock.
Different Stop Losses for Different Trading Styles
There are different kinds of stop losses you should use based on what trading style or investing you are doing.
- Swing trading or Momentum-style trading requires a fairly tight stop loss, as you are only trading the run up or down and exiting before a run reversal.
- For the faster-paced swing-trading style, Velocity trading, an even tighter stop based on the acceleration of price and volume in each chart is used due to the high risk of steep profit-taking after such fast moves in price. The difference between momentum-style and velocity-style stop losses is taught in TechniTrader’s Swing Trading Specialty Course.
- Position-Trading-style stop losses allow you to hold a stock while it platforms up based on value-oriented accumulation.
- Long-Term Investing requires a different stop loss that will allow the stock to move in its normal up-and-down short-term patterns, but it will protect the investor from a catastrophic loss due to an unexpected event.
- Intraday stop losses use intraday price ranges for very tight stop-loss placement.
- Options traders should use stop losses based on whether they are trading the premium or holding for execution.
There is no “one-size-fits-all” stop-loss formula or percentage. Many traders and investors complain that stop losses “don’t work.” What they mean by this is the stop loss is executed and the stock continues up. This occurs because most investors and traders still use the outdated percentage stop loss and have not learned to use technical support levels from the stock chart to avoid being taken out prematurely.
Learn more about the building blocks of trading or investing in the stock market with these starter lessons.