Stop loss, or safety order, is an order placed with a broker to automatically close a position when the price reaches a certain level. You can set the safety order to minimize losses in case of unexpected market moves.
Stop loss is an order to restrict the risks rather than gain profit. Unfortunately, not everyone knows how to use this risk-limiting order and excludes it from their strategies which can lead to disastrous results.
One of the money management rules reads: “Restrict losses for every deal to no more than 5% of the balance.” In other words, a stop loss can go no further than a dedicated number of points depending on the volume of an order for each deal. But this rule is not suitable for every situation. According to long-term charts, a lower stop level is needed to take noises into consideration and a higher one is necessary to fulfill the stop/profit 1:3 principle. Setting a high stop loss level on the 15-minute chart means insufficient profit, while setting it higher means catching noise. For aggressive speculators, such prospects are unacceptable, as when the order volume increases, the stop size reduces. So, where should it be placed?
At first, you need to decide where it is safe to put the stop loss in this particular situation. If you use channels, the stop is usually placed outside the channel boundaries. If you use support/resistance levels, then it should be placed below/above the levels. Thus, in case of a breakout of channels or boundaries, the trend is likely to reverse, and your money will be saved. If there are neither channels nor boundaries around, then the best option for setting a stop loss is above or below the previous sell or buy candlestick. There are several standard indicators that help define exit points - Bollinger and Parabolic. With Parabolic, everything is simple: the stop is placed at the indicator points, and the Bollinger works according to the channel rule.
After defining all the “above” and “below,” you should measure the interval between the expected entry point and the stop loss. If possible losses are less than 5% and the profit is quite obtainable, then you can safely enter the market.
Quite often, these details are not enough to determine whether the exit from the position is set correctly or not. If possible losses are more than 5% and the profit grows sky-high, it is better to wait for a more favorable moment. If the stop level is too low, it is better to give it more room.
As soon as the price has reached a certain positive distance from the entry point, the stop loss may start moving after it. According to the “above/under the previous candlestick” rule, it can catch up with the price at the point where it loses momentum and prepares for a pullback. For these purposes, a floating stop loss was designed, but it is not effective due to the restrictions on points.
Such ways of risks limitation can make it difficult to test strategies and calculate monthly return. However, they are more flexible than a specified size of a stop loss.
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