Trader Insights

What is the Best Stop-Loss Strategy For Traders?

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There are many stop-loss strategies that traders can use in order to protect their investments. The best stop-loss strategy for traders will vary depending on the individual and the type of trading that is being done.

In this article, we will explore exactly what a stop-loss strategy is and take a look at some of the best stop-loss strategies for traders, discussing the benefits and drawbacks of each one – and how you can use them.

What is a Stop-Loss Strategy?

A stop-loss strategy is a technique used by traders to limit their potential losses on any given trade. A stop-loss order is an order placed to buy or sell a security at a specified price. Once the security reaches that price, the stop-loss order becomes a market order and is executed automatically.

Using a stop-loss strategy allows a trader to manage his risk effectively and proactively. It also provides an opportunity to align stop-loss orders with your wider trading plan or strategies by planning your exit points in advance of entering your trades.

Advantages of Stop-Loss Strategies

There are many advantages to using a stop-loss strategy in trading. In fact, it’s recommended that all traders have some sort of stop-loss process in place. Stop-loss strategies allow traders to:

Limit losses on any given trade

By limiting your losses on any given trade, a stop-loss strategy can help to preserve your capital, control your risk potential and protect your profits. This is especially useful when trading in high-risk or high-volatility markets such as Crypto or Forex.

Pre-plan their exit points

Knowing your exit points in advance can help you to manage your expectations and avoid becoming emotionally attached to any given trade. This can be especially helpful when trading high-risk or volatile assets, giving you time to assess what is happening in the market and make a rational decision about your next move well in advance.

Maintain a trading plan and strategy

When you have a predetermined stop-loss in place, it helps to maintain your discipline and adhere to your trading plan. It can also help to avoid making irrational decisions in the heat of the moment which could lead to bigger losses.

Related Reading: What is a Trading Journal and Why Do You Need One?

How To Choose Which Type of Stop-Loss To Use

Stop-loss strategies can vary depending on the trader’s goals and risk tolerance. 

Some traders may use a tight stop-loss strategy, which means they will set their stop-loss order very close to their entry price in order to limit their losses if the trade goes against them. Other traders may use a wider stop-loss strategy, which means they will set their stop-loss order further away from their entry price in order to allow for a larger potential loss.

Which stop-loss strategy you use will depend on your own individual trading personality, style and risk tolerance. A wide stop-loss tends to work best for swing trading, or mid-to-long-term trades, as the trade has more time to move in your favour before the stop-loss is hit. A tight stop-loss is better suited for day trading or short-term trades, as the trade has less time to move in your favour before the stop-loss is hit.

It’s important to find a strategy that works for you and allows you to stay in the game long term. There is no one-size-fits-all stop-loss strategy, so it’s important to find the strategy that works best for you and your trading style.

The Best Stop-Loss Strategies For Traders

Moving Averages

Moving averages are one of the most popular tools used by traders to help them identify a trend and exit points. A moving average is a simple technical indicator that averages price data over a given period of time. When a security is trading above its moving average, it is considered to be in an uptrend. When the security is trading below its moving average, it is considered to be in a downtrend.

A moving average can be used as a stop-loss strategy by placing your stop-loss order below the moving average when buying, or above the moving average when selling. This will help to protect you from getting stopped out of a trade prematurely, and will only allow you to lose a predetermined amount of money on any given trade.

Choosing which type of moving average to use is also important for traders. A fast-moving average reacts faster to price changes, making it the better option for short-term trades. A slow moving average reacts more slowly to price changes, making it the better option for swing traders or long-term trades.

Related Reading: What is FOMO in Trading?

Trailing Stop-Loss

A trailing stop-loss is a type of stop-loss that automatically adjusts your stop-loss order as the market moves in your favour. A trailing stop-loss will keep moving your stop-loss order up as the security moves higher, and will move it down as the security moves lower. This helps to lock in profits on winning trades and limits the amount of losses on losing trades.

There are a few different types of trailing stop-losses that traders can use, each with its own benefits and drawbacks:

  • The most common type of trailing stop-loss is the dollar-based trailing stop-loss. This type of trailing stop-loss orders your stop-loss to move up by a fixed dollar amount for every winning trade.
  • The percentage-based trailing stop-loss is another common type of trailing stop-loss. This type of trailing stop-loss orders your stop-loss to move up by a fixed percentage for every winning trade.
  • The last type of trailing stop-loss is the time-based trailing stop-loss. This type of trailing stop-loss orders your stop-loss to move up by a fixed amount of time for every winning trade.

Whichever type of trailing stop-loss you use, it’s important to set it at a level that still allows you to make a profit on the trade.

Previous Swing Points

Using previous swing points as stop-loss levels can be a very effective way to protect your profits on winning trades and limit your losses on losing trades. A swing point is the highest or lowest price reached by a security during a given trading period.

By identifying previous swing points, traders can use them as definitive stop-loss levels. For example, if you buy an asset at $10 and the swing point is $9, you can set your stop-loss at $8. This will help to protect you from losing too much money if the security falls below its swing point.

To set your swing point stop-loss, identify natural swing points in your chart and place stop-loss above or below those points. You can also use intraday highs and lows, or previous day highs and lows, in this way to set your stop-losses.

Fibonacci Levels

Using Fibonacci levels as a stop-loss strategy offers traders a more objective way of placing stop-losses. Fibonacci levels are mathematical ratios that are used by traders to identify support and resistance levels.

By identifying Fibonacci levels in a security’s chart, traders can use them as definitive stop-loss levels. This can be beneficial, as it allows traders to objectively place their stop-loss without having to worry about being stopped out of a trade prematurely.

To use Fibonacci levels as a stop-loss strategy, identify the key Fibonacci levels in your chart and place your stop-loss at or around those levels. You can also use previous swing points in conjunction with Fibonacci levels to set your stop-loss.

Pivot Points

Another objective way to place your stop-losses is by using key pivot points as your guide. As pivot points are based on price action, market volatility and momentum, they can be a very effective way to measure a security’s current trend.

Pivot points are the point at which the market changes direction. They are calculated by taking the high, low and closing prices of a security over a given time period and then plotting them on a chart. By then using these points as stop-loss levels, traders can protect their profits and limit their losses. Pivot points can be used on all time frames, from intraday to weekly charts.

You Might Like: 7 Effortless Trading Risk Management Strategies

Volatility Stop-Losses

One of the biggest errors in trading is setting stop-losses too close, when market volatility is high, or setting stop-losses too wide when volatility is low. This reduces your potential risk to reward ratio, as you are more likely to get stopped out of a trade prematurely when volatility is high and less likely to get stopped out of a trade prematurely when volatility is low.

To combat this, some traders use volatility-based stop-losses. These stop-losses adjust your stop-loss level according to the current level of market volatility. 

In a volatility-based stop-loss, as market volatility increases, your stop-loss moves further away from your entry price, and as market volatility decreases, your stop-loss moves closer to your entry price.

Volatility-based stop-losses can be a very effective way to protect your profits on winning trades and limit your losses on losing trades. By adjusting your stop-loss level according to the current level of market volatility and wider market context, you can help ensure that you are not missing any profitable trades while also protecting yourself from big losses.

You can also combine volatility stop-losses with your moving averages, pivot points and swing points to create an even more effective stop-loss strategy.

Additional Ways To Determine a Stop-Loss

Chandelier Exit 

A chandelier exit is based on the Average True Range Indicator (ATR) for your trade. ATR is a volatility indicator that measures a security’s average daily range over a given period of time.

Similarly to volatility stops, the chandelier exit is a trailing stop-loss that moves your stop-loss level closer to your entry price as the security’s ATR decreases and moves your stop-loss further away from your entry price as the security’s ATR increases.

Bollinger Bands 

Bollinger bands are another indicator that can be used to set your stop-loss. Bollinger bands are a volatility indicator that measures a security’s price standard deviation from its moving average.

The lower band works well as a long-position stop-loss, as it defines the downside risk for a security, and the upper band can be used as a short-position stop-loss, as it defines the upside risk for a security. 

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