What is a Stop Loss & Why Should You Use One

By Dale Gillham |

One of the key criteria of astute investing is to consider when and how you will take your profits. In other words, you need to consider your exit strategy or how you will apply a stop loss to protect your capital before you invest.

As many of you will have heard me say many times before, trading is about minimizing risk not maximizing profits. Yet it has been my experience that many people actually focus on the latter, with little regard for the former.

In contrast, the most successful investors I know consistently average a good return on their portfolio by minimizing their risk. In fact, not being exposed to heavy losses is, in itself, one of the key principles to making money in the stock market.

What is a stop loss?

Button with the words stop loss

A stop loss is a price point at which you commit to selling a security. It is used either to preserve capital when a recently entered trade turns against you or to protect the profits of a winning trade.

It is important that you decide on your exit strategy before you place a trade, as it is usually too late to do this when a stock is falling simply because your money is on the line, and most investors make emotional rather than rational decisions when it comes to holding or selling a stock at this time.

Furthermore, it is often hard to admit, once you take a position on a stock that you have made a mistake in your analysis, and it is even harder to be objective when losing money.

When calculating a stop loss, you need to use the most recent price available to determine your buy price. This will be the closing price for the previous day or week. It is imperative that you calculate your stop loss before you buy so that you can work out the risk you are willing to take because you may find that you do not want to buy the stock if the investment risk is too high.

When it comes to actually setting the stop loss, there are a number of different strategies you should consider.

Setting a stop loss

Setting stop losses on stocks can be challenging. You need to be close enough to your buy price to ensure you do not lose more than 2 percent of your total capital, yet far enough away that the stock has room to move, in case it falls for a short period of time after you buy into it.

Individuals often set stop losses far too tight and end up losing money, only to find that the stock rises again after they are stopped out.

When setting a stop loss on blue chip stocks, there are a couple of options. Set as a percentage of the buy price, a stop loss is usually 10 to 15 percent below your buy price, depending on the volatility of the stock, as this allows for minor fluctuations in price as the stock settles into the trend.

Setting a stop loss too tight, say 5 percent below your buy price, leaves very little room for the stock to move and will decrease your probability of a winning trade. Alternatively, you can set the stop loss at a price point where you know with high probability that you may be wrong in your analysis.

I recommend calculating both stop losses and then using the one that gives you the least amount of loss.

Percentage-based stop loss

Let’s say you decide you want to buy XYZ Investment Company because you believe it will rise in a nice long uptrend. The stock closed on its last day of trading at $1.00 and you want to purchase the stock when the market opens the next day. Your trading capital is $10,000 and you want to use twenty percent, or $2,000, to purchase the stock, and set a stop loss of 15 percent below your buy price. Your stop loss calculation would be:

Your buy price of $1.00 x 15 percent = $0.15; therefore, your stop loss is your buy price of $1.00 minus $0.15 which equals $0.85. Once the stock closes $0.01 below your stop loss of $0.85 on any day, you would sell to protect your capital.

Now you need to convert this into the actual money, or the trading capital you stand to lose, as you do not want to risk more than 2 percent of your total capital.

Therefore, your calculation would be:

  • $2,000 x 15% = $300 or the amount of the potential loss you will be exposing yourself to on the trade
  • $300 / $10,000 (your total capital) x 100 = 3%.

If you take this trade using a 15 percent stop loss, you stand to lose 3 percent of your trading capital, which is above the allowable risk level of no more than 2 percent of your total capital and is, therefore, unacceptable.

Consequently, you need to reduce your stop loss until you reduce your risk level to 2 percent or below, which, in this example, would equate to a stop loss set at 10 percent.

Stop loss based on your entry rules

The second stop loss you need to work out is the price point where you know with high probability that you are wrong in your analysis. This stop loss is determined using your entry rules.

For example, if you bought when a stock crossed above a trend line, you would know your analysis was wrong if the stock traded back down below the lowest low immediately prior to the stock trading above the trend line. This is because a stock in an uptrend continually achieves higher lows or troughs but when it makes a lower low, it suggests that the uptrend is failing, and so you should exit to protect your capital.

Let's look at an example.

As you can see on the chart below, we have two weekly closes above the down trend line, which is a pretty standard buy signal. The lowest low prior to price trading above the trend line is marked by the lower blue line, while the upper blue line is where your entry price would have been triggered.

Chart showing a stop loss based on entry rules

Weekly Chart of FinNews & Media Click to see the image in full size

After purchasing the stock, price fell away, which means you would have exited the stock at a loss of 5.34 percent loss using this stop loss. Therefore, it makes sense to use the lowest low as the exit for this trade rather than the percentage stop loss of 15 percent, as this would enable you to exit the trade with the least amount of loss.

Remember, once you actually purchase the stock, you need to recalculate your stop loss based on the actual price you paid to ensure your stop loss is set at the right price point.

I outline these strategies and a whole lot more in detail in my latest book, Accelerate Your Wealth - It's Your Money, Your Choice. In fact, as many who have already read my book have said, it is your ultimate guide to making money in the market, so I encourage you to purchase a copy.

So let’s get into this week’s stocks. Watch the video to find out more. 

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