Expert Level

Learn advanced topics about trading strategies, risk management and more.

Lesson 4: How to Calculate Stop Loss

As a day
trader, you should always use a stop loss order on your company. Barring
slippage, stop loss lets you know how much you’re going to lose on a given
trade. When you start using stop-loss orders, you will need to know how to
measure your stop loss and determine exactly where your stop loss order is
going.

Correctly Placing Stop Loss

A good
stop loss strategy involves placing your stop loss at a position where, when
struck, you would know that you were right about the direction of the market.
You’re not going to have the luck of the exact timing of all your trades, such
as buying right before the price starts.

So, if you
buy, give the trade a little room to move before it begins to get up. However,
if you’ve opted to buy a product, you’re expecting the price to go up, so if
the stock starts to drop too much, it’s going to hit your stop loss because you’re
having the wrong expectations about the direction of the market.

As a
general guideline, if you buy a stock, you must lower your stop loss price
below the recent price bar. That price bar you choose to put your stop loss
below will differ by strategy, but this allows a reasonable stop loss position
because the price bounced off that low point. If the price moves below the low
again, you may be right about the price going up, and you’ll know it’s time to
get out of business. Figure 1 (click to open) provides examples of this kind of
tactics.

As a
general guideline, when you’re selling short, put a stop loss above a recent
high price bar. The price bar you choose to put your stop loss above varies by
strategy, but this gives you a reasonable stop loss position because the price
dropped that much.

If the
price is higher than that again, you may be right about the price going down,
so it’s time to exit your market.

Calculating Your Placement

Your Stop
Loss Placement can be measured in two ways: Cents / Ticks / Risk Pips, and
Account-Risk Dollars. Account-Risk dollars contains much more important
information because it lets you know how much of your account you are at risk
of trading.

Cents /
pips / ticks at risk are also significant, but are better suited to simply
relay information. For example, your stop is at X and your long entry is Y, so
you would measure the difference as follows:

Y minus X= cents / ticks / pips at
risk

When you
buy a stock at $10.05 and put a stop loss at $9.99, then you have six cents at
risk per share that you own. When you shorten the EUR / USD forex currency pair
to 1.1569 and have a stop loss to 1.1575, you have 6 pips at risk per line.

It helps
if you just want to let someone know where your orders are, or if you want to
let them know how far your stop loss is from your entry price. It doesn’t tell
you, nor anyone else, how much of your business account is at risk, though.

You need
to know the cents / ticks / pips at risk, as well as the size of your place, to
determine how many dollars of your account you are at risk. In the stock
example, you have a risk of $0.06 per share.

If you
have a stake size of 1,000 shares, you lose $0.06x 1,000 shares= $60 on
exchange (plus commissions). For the EUR / USD example, you are risking 6 pips,
and if you have a 5 mini lot position, measure your dollar risk as:

Pips at risk* pip value* position
size= 6* $1* 5= $30 (plus commission, if applicable)

Your
dollar risk in a future position is measured the same as forex trading, except
that you would use a tick value instead of a pip price. When you buy the E-mini
S&P 500 (ES) at 1254.25 and avoid the loss at 1253, you lose five ticks,
and each tick is worth $12.50. When you buy 3 contracts, you will measure the
dollar risk as follows:

5 ticks* $12.50* 3 contracts=
$187.50 (plus commissions)

Monitor your account risk

The amount
of dollars you are at risk will reflect only a small portion of your overall
trading account. Usually, the amount you lose should be less than 2% of the
balance of your account and, preferably, less than 1%.

For example,
a Forex trader places a 6-pip stop loss order and trades 5 mini lots, resulting
in a $30 trade threat. If you lost 1%, which means you missed 1/100 of your
balance. So how high will her balance be if she’s willing to risk $30 on a
trade? You’d translate this as $30x 100= $3,000. To order to lose $30 on
exchange, the trader should have at least $3,000 to his account to keep the
threat to his balance at a minimum.

Quickly
work the other way to see how much you can lose by selling. If you have a
$5,000 balance, you may lose $5,000/100= $50 per deal. If you have a balance of
$30,000 in your account, you may risk up to $300 per transaction, but you may
choose to risk less than that.

Final Word on Stop Loss Calculation

Always use
Stop Loss, and study your plan to determine the appropriate location for your
Stop Loss order. Depending on the approach, the threat cents / pips / ticks may
be unique for each trade. That’s because every trade should be strategically
placed to avoid the loss.

Stop loss should only be
affected if you forecast the course of the market incorrectly. You need to know
your cents / ticks / pips at risk for each trade, because this helps you to
measure your dollars at risk, which is a much more valuable calculation and
guides your future trades. The dollar at risk for each transaction must
preferably be kept at 1% or less of your trading assets, so that even a string
of losses will not massively deplete your trading account.