Home / Risk Management / 6 Ways To Place Stop Losses In The Most Effective Way – Pros And Cons

6 Ways To Place Stop Losses In The Most Effective Way – Pros And Cons

Following a consistent stop loss approach is very important because it takes out the emotional and impulsive aspect of taking losses that so many traders struggle with. If you don’t really know where your stop goes, and you just put it at a random level, you are much more likely to mess with your stop – widening the stop that is in most cases – when price moves against you.

On the other hand, when you know where your stop goes (and why you place it there), because you use the same approach every single time, you will feel less tempted to break your stop loss rules and adhere to the initial plan.

We show you 6 ways, tools and concepts that can be used for stop placement and we explain the benefits and disadvantages of every single one.

 

Your stop loss is like a seat-belt. You don’t expect to need it every time you get into your car.… Click To Tweet

 

Bollinger Bands

Especially for trend following traders, the Bollinger Bands are a great tool for stop placement and for trailing your stop. In an uptrend you typically see that price moves higher close to the outer Bollinger Bands. A trend that is losing momentum will start pulling away from the outer band and gravitate towards the middle band. Keep in mind that the middle band is a moving average so it makes sense that during a trend price pulls away from the average and once price loses momentum, it comes back to its average.

Thus, trend following traders would place their stop above/below the middle band and trail it along with it as the trend moves on. A trader who prefers a more conservative strategy would place his stop outside the opposite outer Bollinger Band.

 

BollingerBands

 

Trendline and Support and Resistance

Trendlines are a famous tool when it comes to stop placement. As a natural support and resistance level, trendlines are used by many traders and the self-fulfilling prophecy plays into this equation. A trendline-break often signals the end or the weakening of a trend and it makes only sense to have your stop on the other side of a trendline so that you exit your trade when clear price signals are given.

The downside is that drawing trendlines can be subjective sometimes as it’s not always clear if you should go for wicks or candle bodies. Hence, we suggest to draw trendlines connecting the extremes (price wicks) so that you are on the safer side when it comes to stop placement and avoid false signals during premature volatility spikes.

Furthermore, support and resistance levels are often more suited for range environments since some of the concepts, such as moving averages and Bollinger Bands often lose their validity during ranging markets.

Adding a few points as buffer between the trendline and your stop is recommended. It is well known that many traders use trendlines and horizontal lines for stop placement and they make an easy target during squeezes.

 

Trendlines_Support

 

Fibonacci levels

Fibonacci levels also act as support and resistance and, thus, the concepts of support/resistance stop placement also apply to the Fibonacci method. After you have identified a potential trade entry and also found a reasonable 1-2 sequence for your Fibonacci tool, you can use the retracement levels as stop loss levels.

The disadvantage is that you are not always able to find a 1-2 sequence, especially within ranges or early on in a trend, and thus, using the Fibonacci method won’t work 100% of the time.

 

Fibonacci

 

Moving averages

We have briefly touched on moving averages when talking about Bollinger Bands. When price is in a trend, price pulls away from its moving average which makes sense. When the trend slows and reverses, prices will revert back to the average. Just throw up any price chart and see how prices fluctuate around the long term moving average.

Furthermore, the “well known” moving averages, such as the 50, 100, 200 daily moving averages act as natural support and resistance. Thus, it can pay off to have them on your charts and place your stops outside of those moving averages.

 

ATR

The ATR stop loss approach is a so-called dynamic approach since the size of the stop varies based on market volatility. When the ATR is high, volatility is high and price moves and fluctuates more; this would lead to using a wider stop loss to avoid premature trade exits when volatility is high. On the other hand, when volatility is low, you’d use a smaller stop loss and counter the effect of smaller price moves without sacrificing your reward:risk ratio.

The benefit of the ATR approach is that it works well with almost all other stop methods. If, for example, you are using support and resistance for your stops, you would simply add a bit more padding when the ATR is high.

Tip: The Keltner Channel visualizes the ATR on your charts and makes it easy to use the concept of ATR for your stop placement.

 

ATR

 

Price patterns and price formations – the natural price method

This last concept is probably among the most commonly used strategies for stops. When you are trading pin bars, you just place your stop above/below the high. When you trade a Head & Shoulders, you enter on a break of the neckline and place your stop on the other side of the line. And traders who enter trades during pullbacks will typically place their stop just above/below the high/low.

The downside is that such stop loss placement is well known and often easy to spot. We call this the “amateur squeeze” where you see an obvious price pattern followed by a clear signal, but the follow through makes it hard to trade.

In one of his tweets Trader Dante talked about this topic and we borrowed his idea, since he described it perfectly; the image on the left is the result of his idea.  Adding the ATR concept to price stop placement is often the best idea.

 

imperfect_patterns
right-click , save picture as

 

 

The time stop

The concept of the time-stop applies to all previously mentioned stop loss techniques. If you enter a buy trade at a certain price with the rationale that price should go up, but it doesn’t and price just keeps hovering around your entry price, your analysis was wrong and the trade does not work out as anticipated. Staying in a trade where your idea is proven wrong right after the start is a gamble and you are not in a high probability trade. If you have the chance to get out cheaply, get out and don’t hope for something to happen.

 

The worst stop loss concepts

Fixed points & fixed %

Using a fixed stop loss is typically done because traders are lazy and don’t see the importance of having a reasonable stop loss in the first place. Just placing a random stop 5, 10 or 20 points away from your entries violates all sound trading principles. It’s like a basketball player who shoots the ball every time after having made two steps, regardless of where he is on the court and whether he has opponents that can block him easily or whether a team member is positioned better. You always have to put things into perspective and analyze what is happening on your charts. Shortcuts don’t work.

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