Stop Loss Orders

Discussions about stop placement are often related to discussions about risk management. I like to think of stops as falling into one of three categories:

Three Approaches to Stop Loss Order Placement

1) Absolute Dollar Amounts for Stop Loss Orders

With this approach, a fixed dollar amount is risked on a given trade. Many systems are programmed to use a percentage of equity to determine where to place stop loss orders.

One disadvantage to this approach is that the absolute stop loss level may not be related to a meaningful price point on a chart (for example, a previous bar’s high or low). Therefore, stops can be placed at “illogical” price levels; however, this disadvantage can be mitigated with entry points that are close to “logical” stop loss levels (i.e. a trend line or key support or resistance level).

2) Relative Price Levels For Stop Loss Orders

This approach defines a stop loss level relative to some other condition on a chart or price action. For example, some black box trading systems will enter Long and place a stop below an important low. This level may be the lowest low in the last three trading sessions, the low from the previous day, the low from the previous week or some other level that is already on a chart.

A major disadvantage of this approach is that an entry signal can be generated that is associated with a stop level that is too large for the trade. For example, if the system stipulates that the stop for a long entry is below “yesterday’s low”, and yesterday’s low happens to be very far away, due to a large trading range, then the stop loss may risk too much for that trade.

3) Combined Absolute Dollar Amount with Relative Price Level For Stop Loss Orders
This approach uses an “either or” approach to placing a stop loss order. For example, a futures trading system may signal a buy entry. The stop loss would be placed “either” below a level on a chart (a related level) or at an absolute dollar amount - which ever level is triggered first would represent the actual stop loss level. This approach combines the Relative and Absolute Stop Loss approaches.