Stop losses are essential part of successful trading. If you're looking to trade for a living, knowing how to use them correctly is essential for long term success. Placing your stop loss in the correct place is a fine art. You don’t want to keep it too tight otherwise you risk getting stopped out and missing the move you're anticipating. You don’t want to keep it too loose otherwise you will be taking a bigger loss than necessary if you're wrong. So what should you consider in order to place your stop loss to maximize your trading profits?
Focus on Daily Support and Resistance Levels
Whether you're swing trading or day trading, the support and resistance levels on your stocks’ daily chart is most important for determining where your stop goes. Levels on the daily chart will have more impact on a stock's price movement than anything. You should never put your stop on an exact support or resistance level. The market will rarely just go to a resistance point and then reverse on the penny, or support and then bounce. You always want to give them some wiggle room around these levels, give them one five minute candle worth of range from that level. You want to do the same thing when you are playing off intraday support and resistance levels, like HOD (high of day) and LOD (low of day). If you're swing trading, you want to keep a wider stop since you're going for a bigger picture move.
Give Your Trades Space to Work
Everybody wants to risk 50 cents to make 4 or 5 bucks a share. There are only a handful of situations in trading every year that offer this kind of risk reward. Good trades, that you will see on a more frequent basis, will offer you 2:1 or 3:1 risk reward. This is assuming you're placing your stop in the correct location and giving your trade adequate room to play out. Tight stop usually means you’re going to get stopped out.
On all your trades, you have to imagine at what price point does your thesis become invalid. It helps to put yourself in the shoes of someone of the opposite bias in the trade you are taking. If I'm looking to long a stock, at what price level would I think about shorting it? That price level is a good spot to put your stop loss.
How To Avoid Getting Stopped Out Prematurely
If you're a newer or experienced trader, I'm sure you've been in the situation where the market triggers your stop loss, and then completely reverses and then does exactly what you expected. You have probably said this to yourself, "I'll keep a tight stop so I don't have to take a bigger loss". However this mentality will result in you missing a ton of winning trades because you got stopped out right before the move was made. If you look back at all your trades, all of these small losses will add up.
It is important to follow your risk management plan. You should only be risking 1% - 3% of your account on each trade. Many times when a big portion of our accounts is on the line we have a tendency to stop out the moment the stock moves against us because we get nervous. Momentum stocks move quickly and usually have bigger then average ranges.
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