The purpose of a stop loss order is to set a maximum threshold of risk on any given trade. Making sure you are using a stop loss order is a critical component of any risk management strategy. You do have one right? If not, click here to read about creating your own money management strategy.
When you use a stop loss order properly you can minimize your risk and stay in the industry for the long haul.
If you are using a stop loss order incorrectly you will find that it is always getting hit, then the trade reverses and moves immediately back in your direction.
But why is this?
Place a Stop Loss Order â The Wrong Way to Do It
You decide that you will only risk 2% of your account balance on any given trade.
Your account is at $10,000. This means that your maximum loss per trade is $200.
Next you look at the char below, and decide that it is time to get long now.
So you go ahead and purchase 2 contracts of the SP500 futures (e-mini aka ES).
Each point is equal to $50 of profit or loss. You own two contracts.
This means for each point the SP500 moves, you will lose or gain $100 dollars.
Given the above, you place your stop at 2,468 to stay at your 2% maximum risk.
You feel great that you are managing risk, youâre doing everything you have learned. Youâre a pro.
Two minutes later your stop gets hit.
You think to yourself, oh well, at least I managed risk on this trade.
But did you?
What you actually did is take a really low probability trade, which was most likely going to lead to your stop being run.
You actually placed your stop loss the exact opposite way as to how a professional trader would.
How to Place a Stop Loss Order Properly
Now letâs look at the right way to place this stop loss and enter the same trade as above.
When does the upside trend actually reverse?
When sellers are able to take out the 2,466 low in the red circle below:
Most traders will agree that below 2,465 the positions that are long will start to dump their positions and have their stop loss orders activated.
So letâs set our initial stop loss order at 2,464.75.
Since we only have two points of risk available we should not be willing to pay more than 2,466.75 for this trade.
But, this means you would need to wait for a pretty significant dip to get in.
Another option is to go with one contract instead of two.
You would then have up to 4 points of risk to wager this same trade. Because with one contract, moving $50 a point, it takes 4 points to hit your $200 max risk.
Now you can pay as high as 2,464.75 + 4= 2,468.75 for the same trade.
Yes, you will make LESS if you are right about your trade.
But your job is NOT to make more money, your job is to manage risk.
Therefore, you need to be proud that you will LOSE LESS in the event you are wrong. Thatâs how a risk manager thinks.
Overall, the pullback down to 2,468 is a lot more likely and makes for a higher probability trade.
Now look at your trading vehicle of choice and ask yourself, have you been placing stop loss orders the wrong way?
If so, practice the new method and track your results for the next three weeks.
It will make a big difference!
How to Place a Stop Loss Order Properly â
In the beginning I said that most traders get their stop loss order run before the trend continues.
Why is this?
Because most amateurs are in the market to chase gains, they will adjust their risk to favor getting in the market as soon as possible.
When amateurs get emotional and put their money on the line, the professionals use this as an opportunity. Run the stop loss orders on the downside first, squeeze out the rookies, then buy it a few points cheaper for the run higher.
The best part is that a tiny adjustment of how you place your stop loss order will improve your results drastically.
From a professional trader to an aspiring one, making small adjustments to your risk management will bring much bigger returns in the long run then chasing profits blindly on emotion.
I would love to hear from you, did this tip help you turn around your results?
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