How to Decide a Stop Loss

Introduction

Setting a stop loss is difficult because it involves assuming that you have been wrong. Even when we think we are reasonable people, the truth is that psychology plays a great role in our investment decisions. Today, we want to give some tips to decide a good stop loss.

1. Have straight rules.

When you invest, your objective is to achieve a positive expected value. This means that sometimes you will lose, and sometimes you will win. When you lose, you have to cut the losses soon; so when you win, the profits counterbalance and surpass the losses.

This means that you need to set a stop loss somewhere and never break your rule. If the prices go below it, then you sell like a bot –no excuses.

2. Be coherent with your investment strategy.

If when deciding how to invest, you look at weekly charts, when it comes to setting a stop loss, you should also look at weekly charts. If, for example, you use daily charts instead, your stop loss will activate too soon.

3. Take your percentage of winners into account.

You will never know exactly what the probability is that something will work or fail. But if you know your history of decisions, you can know what your percentage of correct movements and wrong movements are.

If, for example, you make the right decision 50 percent of the time, slightly more than 3 percent of the time you will invest in 5 wrong positions in a row. This means that if your stop loss is 20 percent below your buying price, and you do it systematically, investing the same amount, sooner or later this row will come up, and you will lose more than half of your money.

A 3 percent may seem like a low probability, but eventually it happens.

This information will not give you the perfect stop loss for each investment. However, it gives you a max limit you should never accept.

In other words, if your stop loss decision system tells you that this specific investment requires a 20 percent stop loss, you cannot make this investment.

Now, we are not saying that this 20 percent is the right limit. This is just an example. You have to make that decision yourself. If instead, you set a 10 percent stop loss, the chances would decrease to 1.5 percent of the time to lose everything. Maybe that is still too high.

We want to insist that you need a more comprehensive system. This is only to decide your maximum stop loss allowed, which you should only reach sporadically.

Remember that you can also manage risk by investing different amounts each time.

4. Look at lows, mobbing average, and trend lines.

Charts are very useful for setting stop losses.

If you want to be more aggressive and cut your losses quickly, you can set the stop loss at the minimum of the previous period of time. If you look at weekly charts, use the minimum of last week. If you look at daily charts, use the minimum of yesterday, and so on.

Also, you can choose a short moving average. For example, if you look at weekly charts, you can choose the five weeks moving average. If the price goes below it, you sell.

Another option is drawing a trend line that connects the lows the price has done in the past. If the price goes below that line, you sell. This only works if the prices are in an upwards trend with increasing tops and lows.

Lastly, you can set a longer moving average — for example, the 30 weeks (if looking at weekly charts) moving average. Typically, this option will allow the price to go lower than the others mentioned above. So with this one, you will need to accept the chance of losing a bigger amount. But in exchange, you can be more sure that the trend has really changed and that the price is not going to turn up again to reach a new top just after you sell.

*Please keep in mind that this is not financial advice. Make your own decisions and consult a financial advisor.

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