How to Choose the Right Stop Loss

Recently, I received a question about what I recommend doing with a stop loss order. I thought other readers might have the same concern, so I wanted to share my answer.

Here’s the question…

Stop loss orders give me peace of mind. What would you recommend on that? A percent trailing stop maybe? Feedback would be highly appreciated.

– Sherif S.

Hi Sherif, thanks for writing in.

Most investors know that setting stop losses is key to managing risk in the markets.

Without a stop loss, an investor doesn’t have a clear and concise way of knowing when to cut a position.

So rather than exiting at a predetermined level, investors without stop losses often end up cutting a position based on pure emotion… Typically, when they can no longer bear the pain.

And that’s something that could end up costing them a lot of money.

However, when it comes to setting stop losses, it’s not always easy to know exactly where to place them…

Stops in a Volatile Market

Some investors stick with a simple fixed stop loss – a fixed percentage or dollar amount below the stock’s price.

But given its rigidity, it can be hard to get it right across different market conditions… like when a stock becomes volatile and starts swinging unpredictably.

However, one helpful method that offers a more nuanced solution is one that uses the Average True Range (ATR).

The ATR calculates the average range of a stock (or index) over the preceding 14 days (some might use a longer time frame).

So if volatility is steadily increasing, then so will the ATR (and vice versa). It’s useful because it reflects the current volatility of that stock (or index).

Since stocks typically fall more dramatically than they rise, the ATR usually increases during pullbacks.

Just take a look at the SPDR Dow Jones Industrial Average ETF Trust (DIA) chart below…

SPDR Dow Jones Industrial Average ETF Trust (DIA)

Source: eSignal

When DIA’s stock price rose from ‘A’ to ‘B,’ the ATR fell from $6.78 to around $4.35… And when DIA fell from ‘B’ to ‘C,’ the ATR climbed (from around $4.35) back up to $6.50.

While they’re not an exact mirror image, you can see a clear inverse relationship between the ATR and DIA’s stock price.

To give a stock enough room to move, typically an ATR-based stop is set as a multiple of the ATR… often three, four, or five times.

For example, if the ATR is $5 and a stock is trading at $100, a trader using a multiple of three times ATR will have a stop loss at $85 – or $15 below the stock price.

Remember, the goal is to capture as much of the move as possible. The whole idea of setting a stop is to protect traders from a move in the opposite direction – without being stopped out unnecessarily.

If we set our stop too tight (too close to the current price action), then we run the risk of getting stopped out prematurely… meaning we could be giving up plenty of profits.

So how do you apply it?

Using ATR With Trades

How you use an ATR depends on your time frame.

For instance, a short-term trader who wants to capture lots of little profits (without risking too much) might use a lower multiple (like two or three).

So if the ATR in our DIA example is $5, then you might only allow the stock price to fall $10 (using an ATR multiple of two) before you’re stopped out.

However, a long-term trader – one who wants to capture a move that may last for months or years – might use a much higher multiple (five or six).

It should be enough to capture the full potential of an up move without getting stopped out by a quick pullback.

The key is to look at the price chart and work out what multiple suits your goal from the trade.

Like anything in the markets, it’s not a perfect solution. However, it certainly helps put the odds in your favor.

Using an ATR as part of a stop loss strategy helps fine tune your exit strategy.

Most importantly, it lets you have a defined exit point and gives the stock sufficient room to move so that you’re not stopped out prematurely.

Regards,

Larry Benedict
Editor, Trading With Larry Benedict

P.S. If you’d like a question addressed in a future mailbag, you can write in to [email protected].