daytradingskills

A lot of traders do not have concrete ideas for placing the stop loss. They have no problem entering a trade, that may be based on elaborate technical analysis, but exit is left to their wisdom, or shall we say, their whims and fancy.

Stop orders provide a vital safety mechanism and are an important part of the trade management philosophy of every successful trader. A stop-loss order can cause you to sell prematurely if you put it too close. On the other hand, a stop loss that is too far away will not offer much protection. Stop orders should not be taken in isolation but must integrate cohesively into the overall trade management strategy so that losses are minimized and profits are allowed to grow. Traders should not confuse stop losses with buy stops, which are frequently used to trigger an opening position rather than closing the trade.

Although stop orders form the backbone of risk and trade management, their importance is generally underestimated by new traders. If you do not use a stop-loss, you are inviting a painful lesson from the market. If you’re not watching, or if your indicators leave you indecisive, or if the market takes a sudden turn you could lose most of the value of a position.  If you're using margin, you could lose more than your entire investment. Although stops do not always guarantee the protection as planned, but do well most of the time.

Suppose that you placed your stop loss order at Rs. 44, the stock may not always get sold at that price. Remember that the stop loss becomes a "market order" when the stock falls to the trigger price. The order would then be executed at the best price available for the next transaction. If for whatever reasons the stock were to gap down from above to well below the price of your stop loss order, your stock will be sold at the next available price below the gap.

Placing stop is an art and not an exact science; every trader has to work out his own strategy based on the nature of his risk tolerance. The initial stop also govern the trade size through the vital position sizing relation of money management system. The basic considerations for decision on the placement of an initial stop loss are:

(1) Trading timeframe, and
(2) Volatility of the stock

Longer timeframes necessitate wider stops, and shortened trading timeframes warrant tighter stops. Similarly, a highly volatile stock deserves a wider stop, while a “quiet” stock which tends to move very slowly can be traded with a tighter stop. A volatility-adjusted stop has further advantage – it is applicable to any time frames.