Where to Put Those Stop Losses?

Many people say that a spread bet should never be made without a stop loss order. Most spread betting companies offer stop losses, and for some, including Cantor Index, Capital Spreads and Financial Spreads, stop losses are automatic.

Capital Spreads said that its automatic stop losses allowed it to avoid large margin calls after an unexpected interest rate cut by the US Federal Reserve caused the market to rally. CMC Markets and City Index reported that a number of their clients had not used stop loss orders, and took a major hit.

Choosing the best point for a stop loss depends upon three circumstances: the time horizon of a trading strategy, the volatility of the instrument and market conditions such as trading volumes and news flow.

The most widely-used strategy is to identify major resistance and support levels, and put a stop loss order marginally beyond these. These levels depend upon your time frame. Identifying resistance and support levels is straightforward if you use a respectable charting package and good price data. Round or landmark numbers and previous highs and lows are often significant. A stop should never be set at a round number, so you should choose £2.51 rather than £2.50 because more stops are likely to be at a psychologically-pleasing level, and you could find yourself to the rear of the queue for execution.

Another way in which you can ensure your stops are correctly set is to refer to the average true range (ATR), which measures the volatility of an instrument. It is the difference between the peak and trough of a day over a period that is usually two weeks. You could use three times the 10 day ATR for long-term trades, 1.5 ATRs for trades of five to 10 days, 1 ATR for trades of between one and three days and 0.25 ATR for intraday trades. ATRs rise with volatility, so stops will become wider as volatility increases. A less effective method is to set stop losses a certain percentage away from the current price.

If a position goes against you, you should never move your stop further away. This is a most undisciplined trading style which can compound your losses. Stops are set for a reason.

Stop losses should be tight, even if this means you exit trades sooner than you would have liked. You can still make money even if you are correct less than half of the time when you keep losses small: the traders of some practitioners are profitable only three or four times out of ten, but they still make money because their stop losses were tight.

Knowing that markets follow cycles can enable you to ride out fluctuations and not take profits – or losses – too early. A rocket stock is a wonderful thing, but sometimes instruments need to perform a few orbits before they blast through the atmosphere.

Your stop loss strategy should take account of whether the market is bearish, bullish, or sideways and the magnitude of your stake. More than 20 percent of a margin amount should never be risked on a single trade.

Stop loss orders should be integral to trading, and knowing what is above will make you more effective.