As we already know, stop losses are part of risk management and money management, aspects that we must understand very well in order to be profitable in the long term.
How to Set Stop Loss?
It should be placed where we think the price will never arrive. That is why if it arrives, it takes our stop. It means that besides being the stop loss a tool to protect the capital, it is also a confirmation of an error based on statistics. We already know that in trading we will have a percentage of failed trades, caused by signals that did not work as expected.
For example, if you are trading the bounce at a resistance (we will assume a double top), the stop loss by logic should be above that resistance (the top). Since your strategy was to trade downwards after that bounce.
Why should the stop loss be above the ceiling? Because if the price rises above it, it was not a double top. Remember that we saw in the technical analysis that the patterns of the figures are not always fulfilled.
The level to cut losses should not be random, on the contrary, it should be based on technical analysis. Some people do not know how to use it and that is why they constantly lose money.
We show this example of the double top with a chart to make it easier to understand:
This is what happened next. The figure happened as we expected, but if it hadn’t, we were covered with a stop above the high.
We will calculate the size of the position in this example to ensure that the stop is properly placed (we assume a trader who invests 50% in a trade, although it is a lot, there are people who do it and we will take it as an example simply to understand the issue of the placement of the stop), with the following data from a trading account:
Total capital: u$s10.000
% loss per trade (capital at risk): 1%
% of capital in 1 trade (invested capital): 50%
Set Stop Loss:
To cut losses with this chart, the stop must be above the high (if they just bounce off the same level, it will be above that level).
The maximum is at u$s21.05 so we give a few cents of margin and place the stop at u$s21.20.
Entry:
We assume that we place a sell order (since we are short, to the downside) limited near the close of the previous session, i.e. the last green candle (or it could also be the high of the previous session) at u$s20.82 and that our order is executed.
Trade size:
The account is u$s10,000 and we will risk u$s100 (1% of the account). As the stop is at u$s21.20 and the entry is at u$s20.82 the risk assumed is u$s0.38 per share sold. Therefore, to determine the size of the operation, we must first subtract the broker’s commissions for both the entry and exit (we will use u$s10 as an example, it depends on the broker). We would be left with $90. As we are going to risk u$s0.38 for each share, then we will be able to sell 236 shares. This calculation comes from making u$s90/ u$s0,38 = 236,84 and rounding down the result. Then the maximum position will be u$s5003.20 since in case of stop, we will have to buy them at that price, that is to say we sold 236 shares at u$s20.82 and bought them at u$s21.20, leaving us a loss of u$s89.68. But if the position is a winning one, assuming our target at u$s18.03 we will have done the following: we sold 236 shares at u$s20.82 and bought them at u$s18.03, that is, we sold u$s4913.52 and bought u$s4255.08, leaving us with a profit of u$s658.44.
As you will notice, the risk is controlled, since in case of loss we have u$s89.68 (the u$s90 that were left, but it gives a few cents less because we rounded the amount of shares) plus the u$s10 of commissions.
This can be seen in the following graph calculated by TradingView. The red part is the stop and the green part the target, as you can see it says stop 0.38 and in the green part QTY 236, which is the amount of shares.
We put u$s18.03 as it is a possible support for the example but you could have put more or less, depending on how you trade.
This is what the chart would look like once the stock closed and we placed the sell limit order for the next day or before the opening of the next day.
And what happened after that:
