Stop losses, in terms of online trading, are a set price at which your shares will sell automatically. Stop losses are the reason why I believe trading shares is not a risky business (as too many people think). Whenever you go long of short on a share, brokerage accounts allow you attach stop losses for free to a share.
The standard stop loss
Is simply a set price at which the share sells automatically.
Stop Loss Example 1
- you buy a share on an up trend @ £20.00
- you put a stop loss in @ £19.75
- the price could go down to £19.75 and your shares will be sold automatically
- meaning you will only ever lose 1.25% of your investment ((100/20)x19.75)
- however, if the stock went up you would set to gain a lot more than 1.25%!
Stop Loss Example 2
Helmerich & Payne Inc | January 2007 - August 2007
(chart courtesy of Telechart)
- the share hits the resistance line four times at points 1,2,3 and 4.
- you buy the share at point 5 when it move above the resistance line
- and put you stop loss at point 6 to sell the share at $28.53 (risking a loss of around 1%)
- however as the chart shows, it was possible to gain almost 25%!
Lets put that in monetary terms
- you buy 130 shares at $28.90 (point 5) = $3,757 (around £1,870)
- you risk around 1% = $37 (£18) [its important to note you will often lose this 1%]
- however in this example you could gain up to 25% = $939!! (£470)!!
- meaning that you could lose a lot more trades than win and still make money!
Stop Loss Example 3
Example 3 is going to show how stop losses work for selling (shorting) as well as buying.
Pulte Homes | June 2006 - April 2007
(chart courtesy of Telechart)
- the share hits the resistance line two times a points 1 and 2.
- you sell the share when it breaks the resistance line* at point 3.
- and put the stop loss at point 4 to buy back the share if it hits $30.50 (risking about 1.1%)
- however as this chart shows you could set to gain around 15%!
In monetary terms
- you sell 400 shares at $30.19 (point 3) = $12,076 (around £6,000)
- you risk around 1.1% = $120 (£60) [again, its important to note you will often lose this 1%]
- however in this example you could gain up to 15% = $1,811!! (£900)!!
Percentage stop losses
Percentage stop losses are similar to standard stop losses, they both have set at a fixed price at which the share sells. However the difference is in the way you set them. Standard stop losses you choose a number e.g. 19.75, but with percentage stop losses you choose a percentage of your trade you are willing to lose.
Example
- You buy 100 shares @ $20 = a $2000 investment
- You set the stop loss @
3%
- The stop loss will be triggered if the share price reaches $19.40
- and the maximum you will lose is $60
Trailing stop losses
Guess what, it gets better! There's not just two kinds of stop losses, there's another called a trailing stop loss. This type of stop loss follows the last price (current price) by a percentage or a numeric monetary value set by you.
Examples (based on a 3% trailing stop loss)
- If you set a 3% stop loss then and your stock drops 3% then it is automatically sold
- If your stock drops 2.5%, goes up 1% then back down by 1.5% then it is automatically sold
- If your stock rises 8% and then drops 3% then your stock is sold at a 5% profit.
- If your stock rises 9% then the minimum you take away is 6% profit etc.
- If your stock rises to 7% then your stop loss will stay at 4% until the stock rises over 7%, regardless of how much movement has taken place between the 4.01% and 7%
profit levels.
The trailing stop loss is a great way to lock in your profit whilst still cutting any losses short. However the disadvantage of a trailing stop loss is that if a stock's price is erratic and your stop loss % is small then you are likely to be cut out of a trade.
Improving the psychology of trading
It is important to note that stop losses are important for the psychology aspect of trading as you have a set price to dispose of the share. By setting a stop loss, you avoid the situation of "I'm going to get rid of it in a minute as soon as it makes a bit of money back that i've lost " and then lose even more! This is a classic thought process that goes through a traders head and by setting stop losses, the chance of this thought process is eradicated.
