"Cut your losses short and let your winners run."
This is perhaps the oldest advice in trading. And the stop-loss is how you do it. But setting stops is both an art and a science. Let's explore how to do it right.
What Is a Stop-Loss?
A stop-loss is an order that automatically closes your position when the price moves against you by a certain amount. It's your safety net—your predefined exit point if things go wrong.
Without a stop-loss, a small losing trade can turn into a catastrophic one. With a stop-loss, your maximum loss is defined before you even enter the trade.
Why Stop-Losses Are Non-Negotiable
1. Capital Preservation
Your number one job as a trader is to protect your capital. A series of small losses is recoverable. A 50% drawdown requires a 100% gain just to get back to even.
2. Emotional Protection
Pre-setting your stop removes emotion from the equation. Without a stop, you're likely to hold losers too long, hoping for a recovery that may never come.
3. Risk Quantification
With a stop, you know your worst-case scenario before entering. This allows for proper position sizing and risk management.
Methods for Setting Stop-Losses
Method 1: Support and Resistance
Place your stop just below a key support level (for longs) or above resistance (for shorts).
Logic: If price breaks through that level, your trade thesis is likely invalidated anyway.
Tip: Don't place stops exactly on the level. Give it some buffer room to account for normal price noise.
Method 2: ATR (Average True Range)
Use the ATR indicator to set stops based on market volatility.
Example: If ATR is $2, you might set your stop 2 ATRs away ($4) from your entry.
Logic: More volatile markets need wider stops to avoid getting stopped out by normal fluctuations.
Method 3: Percentage-Based
Set stops at a fixed percentage from your entry.
Example: 3% stop-loss on every trade.
Pros: Simple and consistent. Cons: Doesn't account for chart structure or volatility.
Method 4: Chart Pattern Invalidation
When trading a pattern, place your stop where the pattern would be invalidated.
Example: If you're trading a head and shoulders, stop goes above the right shoulder.
Common Stop-Loss Mistakes
1. Stops Too Tight
If your stops are constantly getting hit before the trade moves in your favor, they're probably too tight. Give your trades room to breathe.
2. Stops at Obvious Levels
If you place stops exactly at round numbers or obvious support levels, big players may "run" those stops before letting the market move. Add some buffer.
3. Moving Stops in the Wrong Direction
Never move a stop-loss further away to avoid being stopped out. This destroys the entire purpose of having one.
4. No Stop at All
"I'll just watch it closely" is not a strategy. Unexpected news, internet outages, or simply falling asleep can turn a small loss into a wipeout.
Trailing Stops: Locking in Profits
A trailing stop moves in your favor as the trade becomes profitable, but never moves against you.
How it works: If you set a $5 trailing stop and price moves $10 in your favor, your stop is now at +$5 profit. If price reverses and drops $5, you're stopped out—but with a profit.
This lets you "let winners run" while still protecting gains.
Position Sizing and Stop-Losses
Your stop-loss directly determines your position size. Here's the formula:
Position Size = (Account Risk $) / (Stop-Loss Distance)
Example:
- Account: $10,000
- Risk per trade: 1% = $100
- Stop-loss: $2 from entry
- Position size: $100 / $2 = 50 shares
Practice Makes Perfect
Setting proper stops requires understanding price structure, which comes from chart time. Use ChartMini's simulator to practice identifying key levels and setting stops on historical data.
The more you practice, the more intuitive stop placement becomes.
Conclusion
A stop-loss isn't just a safety feature—it's a fundamental part of your trading strategy. Master the art of stop placement, and you'll protect yourself from the losses that destroy most traders.