Stop loss is essentially a risk tolerance limit or level used frequently by investors or traders to minimize their losses into a limit. Stop loss is frequently used in the stock market by experienced and successful traders. It allows them to limit their losses so that they can cover their losses with further profits. Stop loss is basically a part of money management. A technical analyst should know the importance of money management and stop loss.
A stock can go in favor or against a trader or investor after taking position. If the trade goes against the trader or investor, they use stop loss to cut their losses into short and save their valuable investment from large losses and margin call. In a long position, stop loss is set to a lower price level. In case of a short position, stop loss is set to a higher price.
There are different types of stop losses. These are described below.
Fixed Stop Loss:
A fixed stop loss is generally a defined percentage from the entry price. If you bought a stock at $100 and your stop loss is at 10%, then your stop loss is at $90. Inversely, if you sold a stock at $100 and you are using 10% stop loss, then your stop loss is at $110. Generally this type of stop losses are neither too tight nor too wide.
Logical Stop Loss:
This type of stop loss is determined using support resistance, Fibonacci retracements, trendlines, high-low points, pivot points etc. Logical stop losses are more popular and frequently used than other types of stop losses. Price generally respects psychological levels like support resistance, Fibonacci retracements, trend lines rather than respecting significant percentage of the price. This is why this type of stop loss is more popular than fixed stop loss method. Support and resistance lines are most popular in case of determining logical stops. A stop loss order is placed at short term support line in case of a long position. In case of a short position, a stop loss is generally placed at nearby short term resistance level.
In the daily chart of BBY (given above), we can see entry points and stop loss levels for a long position. Entries are marked by blue colored circles and are determined by bullish crossovers of MACD indicator. Stop loss levels are placed at nearby support lines.
Indicator Based Stop Loss:
This type of stop losses are determined by bearish signals or sell signals of indicators. This type of stop losses are not predetermined as you never know where the sell signal will actually come. If you buy a stock after a bullish crossover of MACD indicator and see a bearish crossover soon after your entry while you are still in loss, then it is a signal for you to cut your loss in short. This type of stop loss is also popular and effective as logical stop. In this type of stop loss, you would be able to exit when your entry conditions do not exist anymore and your trade has gone against you.
Many traders face hard time to determining suitable stop loss strategy for their entry strategy. So, before determining a stop loss strategy you should check out which type of stop loss method suits your entry strategy most. Many traders also tend to use several methods of stop losses at a time which can be dangerous and can increase the risk. Traders should not use various stop loss methods at a time.
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