🛑 Stop losses: where to put them and what they cannot do

🎯 In 30 seconds: A stop loss is the price where you admit a trade is wrong and get out. You decide it before you buy, and it sets your position size. Good stops sit where the reason for the trade is clearly broken, often just past a recent low or a few average daily ranges away. A stop order is a trigger, not a guaranteed price: if a stock gaps past it, you get the next available price, which can be much worse.

What a stop loss is, and why you need one

A stop loss is a planned exit for a losing trade. It can be an actual order sitting at your broker, or a price you watch and act on yourself.

A sell stop order, in the SEC's words, "is entered at a stop price below the current market price." When the stock trades at or through that price, the order becomes a market order and sells. A buy stop order does the same thing above the market, and is how short sellers cap their losses.

Stops do three jobs:

• They cap the loss. Without an exit, a 5% loss can become a 50% loss while you "wait for it to come back". The math in Risk comes first shows why that is so costly.
• They set the size. You cannot use the position sizing formula without one: shares = dollar risk / (entry - stop). See Position sizing.
• They take the decision away from the moment. Deciding where you are wrong while calm is easier than deciding while watching a red number grow.

Four ways to place a stop

The rule that matters most: put the stop where the trade idea is wrong, not where the loss feels uncomfortable. Here are four common methods, all using one hypothetical stock bought at $40.00.

1. Structure stops. Place the stop just beyond a price level that should hold if your idea is right, such as the most recent swing low or a support level. Say the stock bounced from $37.80 last week. If it falls below that, the bounce has failed. A stop at $37.60 gives a little room for noise.

2. Volatility (ATR) stops. The Average True Range (ATR) is the stock's typical daily range, including gaps. If ATR is $1.20, a stop 2 x ATR below entry sits at $40.00 - $2.40 = $37.60. The idea is to stay outside normal daily wiggle. See Volatility tools.

3. Percent stops. Exit if the stock falls a fixed percentage, such as 8%: $40.00 x 0.92 = $36.80. Simple and consistent, but it ignores both the chart and the stock's normal volatility. 8% is tight for a jumpy stock and loose for a calm one.

4. Time stops. Exit if the trade has not worked within a set time, for example "if the stock is not up at least 1R within 10 trading days, sell." This frees money stuck in trades that are going nowhere and is often combined with a price stop.

In this example the structure stop and the 2 x ATR stop agree at $37.60. When two methods land in the same place, that is a good sign. When they are far apart, prefer the structure level and reduce the share count to keep the dollar risk the same.

Stop-market vs stop-limit

There are two main kinds of stop order, and they fail in different ways.

The SEC's bulletin gives an example of a stop-limit with a stop at $3.00 and a limit at $2.50. It only sells at $2.50 or better. If the price drops straight to $2.20, nothing sells.

For a stop whose job is to get you out, most traders accept the slippage of a stop-market order. A stop-limit protects the price but not the exit. Order types in general are covered in Order types.

Two more details from the SEC: brokers differ on whether they trigger stops from the last trade price or from quotes, and a short intraday dip can trigger a stop even if the stock closes higher. Ask your broker which rule it uses, and whether stops can trigger outside the regular session.

Gaps: when the stop price is not the exit price

A gap is when a stock opens far from the prior close, usually after news released while the market was closed, such as earnings. Your stop cannot fill at a price where nobody traded.

Using the trade above: 41 shares, stop $37.60, planned loss $98.40. The stock opens at $34.00.

You cannot remove gap risk, but you can manage it:

• Keep risk per trade small, so a 2.5R surprise is a bad day, not a disaster.
• Know the earnings date before you buy. Check the earnings calendar. Many swing traders close or shrink positions before a report.
• Be careful with very small, thinly traded stocks, where gaps are larger.
• Remember that extended-hours trading has less liquidity and bigger price swings, as the SEC notes. A price you see after hours may not be one you could trade at.

Mental stops

A mental stop is a price you plan to act on without placing an order. Some traders use them to avoid having their order "seen" or triggered by a quick dip.

The honest problem: mental stops only work if you are watching, and only if you act. Most beginners do not. Research on the disposition effect shows investors hold losing positions too long, and a mental stop leaves that tendency in charge. See Trading psychology.

If you use one, write it down, set a price alert at that level, and treat the alert as an order you must execute.

Moving stops: breakeven and trailing

Moving to breakeven means raising the stop to your entry once the trade is up, say by 1R. In our trade, at $42.40 you would move the stop from $37.60 to $40.00. Now a reversal costs you nothing except costs.

The trade-off is real. A breakeven stop often sits right where normal pullbacks reach, so you get stopped out of trades that would have worked. Test it in your own records before making it a rule.

A trailing stop moves up as the price rises and never moves down. It can be a fixed dollar amount, a percentage, or a multiple of ATR. Many brokers offer trailing stop orders that adjust automatically.

In that example, with a 10% trailing stop from the start, the first stop is $36.00, so R is $4.00 a share and the formula gives 25 shares. The stock peaks at $47.00 and the stop ends at $42.30. Selling near $42.30 gives about +$2.30 x 25 = $57.50, or roughly +0.6R.

Notice what the trailing stop cost: the stock was up $7 at the peak, and the trade kept $2.30 of it. Trailing stops protect gains but always give some back. Tighter trails give back less but get shaken out more often. There is no setting that avoids both.

A short stop-loss checklist

1. Find the level where the idea is wrong (structure, ATR, or both).
2. Add a small buffer beyond it.
3. Size the position from that stop.
4. Check for earnings or other scheduled news before the planned exit.
5. Enter the stop order right after the entry fills.
6. Only ever move it in the direction of the trade.

Try it

Open a daily chart of any stock on your Watchlist. Mark the most recent swing low, and find the stock's ATR. Write down three stops: structure, 2 x ATR and 8%. Compute the share count for each at $100 of risk. Then place the structure version in the paper portfolio with a real stop order, and record whether it fills at, below or above your stop price.

Sources

• Investor.gov (SEC): Investor bulletin, stop, stop-limit and trailing stop orders
• Investor.gov (SEC): Types of orders
• Investor.gov (SEC): Extended-hours trading, investor bulletin
• Odean, Journal of Finance (1998): Are investors reluctant to realize their losses?