Stop-loss orders allow traders to limit their losses in the stock market. Selecting the best price level for a stop-loss can be one of the most important trading decisions a stock investor makes. Some traders use a percentage of their profit target to set order levels, but different strategies can be better suited to different scenarios. Understanding common strategies for placing stop-loss orders can help you to increase your consistency as a trader.
As the name implies, a stop-loss order prevents a loss on a trade past a designated point. They are placed within a software trading platform and attached to an existing trade. When that trade is live in the market a stop-loss immediately closes a position when the price of a given asset hits a certain level. Stop-losses are placed below the market price for buy orders and above it for sell orders or short sales.
Setting your stop-loss as a percentage of your profit target can keep your risk-to-reward ratio in favorable territory. Having your stop-loss at 50 percent of your profit target or less can increase your chances of earning a net gain over the long term. For instance, buying a stock at $25 and intending to sell when it reaches $27 means your profit target is $2. If you set your stop-loss at $24 it will be $1 away from the purchase price, or 50 percent of the profit target.
Using the maximum loss per trade from your risk-management plan can inform your stop-loss levels. Setting a maximum loss per trade can ensure that your trading account does not lose too much of its value in a single losing day, especially when used alongside a target for the maximum loss per day. With this method, investors calculate how much a current trade can decline, given the current price and the number of shares in the trade until it reaches the maximum loss for the trade. Consider an investor with a $100 maximum loss per trade. If the investor buys 50 shares of a $10 stock, he will lose $50 on the trade for every dollar that the price declines. Thus, he could set a stop-loss at $8 -- the point at which he would have lost $100 on the trade.
Support and Resistance
When a stock's price rises above a resistance level or falls below a support level, it is often likely to continue in that direction. Thus, setting a stop-loss order at these points can get you out of a trade that is likely to lose more value than it already has. These stop-losses can be far enough away to avoid pulling you out of a losing trade that is about to turn back in your favor.
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