Setting Stop Loss Levels in Day Trading
Where do you put your stop when day trading? Let's find out...
A quote by legendary trader Bruce Kovner perfectly sums up the importance of stop losses:
“I know where I’m getting out before I get in. Whenever I enter a position, I have a predetermined stop. That is the only way I can sleep.”
While a contentious topic, it’s often better to use a stop rather than not have one, whether you’re a day trader, scalper, or swing trader.
Yet, like any trading technique, stop loss orders are more art than science, given the differing market conditions, market volatility and trader discretion.
Let’s dive deeper into this topic, exploring the numerous stop loss trading strategies for day traders.
Table of Contents
What is a stop loss?
A stop loss (or stop) is an order which autonomously closes a position once it breaches a predefined loss amount.
Stop losses are the most recommended way to manage risk.
Neglecting this risk management approach often leads to traders taking larger losses than expected or blowing out their accounts entirely.
Controlling losses is essential for any trading strategy.
It’s impossible to position-size appropriately without referencing a stop loss. Yet, correctly using stop loss orders is key to securing the most profit possible.
What are the different types of stop losses?
Let’s first consider the various types of stop losses you will encounter in any financial market. We technically have three main types, along with another that is more discretionary.
Basic stop loss order
A basic stop is the most common type, where a trader inputs the price at which they wish to exit the market in case of a losing position. The order appears above the current price (for a bearish trade) or below the current price (for a bullish trade).
Traders may apply a stop after or before a live market order. Alternatively, the stop can also be attached to a pending order. These stops can transition into a trailing stop, bringing us into the next stop type.
Trailing stop loss
A trailing stop is a dynamic stop loss order type that automatically locks in profits at incremental levels as the trade moves favourably.
The trader chooses how many points, pips or ticks they would like the stop to move to secure gains while giving reasonable space for price fluctuations.
The trailing stop loss remains fixed at a specific price until the market moves in the opposite direction and closes the entire position for whatever profit.
Such a stop progresses in one direction and cannot be made to travel higher or lower when the market moves against your trade.
Stop limit order
Stop limit orders are a rarer kind of stop loss which aren’t available with all charting platforms.
They are a conditional stop merging the features of a standard stop and a limit for minimal risk. The idea is to set two price points: a stop price and a limit price.
Traders will first set the stop price, the point at which they want the trade to be triggered. Afterwards, the limit price comes into play, the maximum price they’ll pay or the minimum price they’ll receive for the trade.
After the stop price is reached, it becomes a regular limit order to buy or sell at the limit price or better.
Mental stop
A ‘mental stop’ merely refers to a method to limit losses without a traditional stop loss order. The trader mentally decides when they should exit positions and closes them manually.
Mental stops are the riskiest way to minimise your downside and, more often than not, lead to more losses than anticipated. The main reason revolves around being unable to tell how far a market goes against you.
Most traders using this approach believe it’s a more flexible method that prevents the common occurrence of a stop order triggered only to see a market move in the intended direction of your trade.
The different stop loss trading strategies
Now that we covered the different types of stops, it’s time to look at the various strategies around them.
Risk-to-reward stop loss strategy
This stop loss strategy is a way of placing a stop based on a desired risk-to-reward ratio. For instance, if the ratio is 1:5, where at least a 200-pip profit target is possible, the stop size is 40 pips (as in the image above).
The trader focuses more on achieving the most optimal entry, which may result in them having a slightly narrower stop loss to increase the potential. It may seem like there is no rhyme or reason for their fixed stop loss placement.
However, they would use references like the nearest support and resistance and other techniques.
Yet, the most crucial aspect of a favourable risk-to-reward is to maximise their profit. Also, a trader is flexible in moving their stop as the position moves for them or where they can aim for greater gain.
Trailing stop loss strategy
Day traders and other short-term traders commonly use a trailing stop loss order strategy rather than a fixed stop.
The main downside is that it can ‘kick out’ traders too early from their positions depending on how close they’ve placed the trailing stop.
Yet, some traders may place them closer than usual in fast-moving market conditions to secure the most profit while remaining in the trade.
Let’s cover a simple example using the 30-minute chart of GBP/AUD.
Assume you entered the market at the 1.88000 price point with a 40-pip stop loss order at 1.87640.
The trailing stop loss order gets activated once the price moves to 1.88400, where your stop loss order goes to 1.88000.
Note how this pattern continues at every 40-pip move until the trade is closed once GBP/AUD retraces more than 40 pips and the price reaches the trailing stop at 1.89600.
Indicator based stop loss strategies
Some traders set their stops using technical indicators, which is often a more objective way.
You’ll want to stick with volatility indicators like the Average True Range (ATR) and Bollinger Bands.
The ATR is an effective stop loss strategy since it shows the average number of pips a market has moved within a given time frame.
So, your goal is to set your stop above this range.
The ATR adapts to the changing market conditions. Day traders would place a larger stop loss during high volatility or a tighter stop loss when volatility is on the lower end.
Using the Bollinger Bands is another alternative, as it’s also a volatility indicator. The outer bands would represent areas to place your stop loss order, as a break outside suggests greater momentum against your trade. The middle band can also guide traders who prefer to trail their stops manually.
Finally, another decent technical tool is Fibonacci, which provides many support and resistance points. These can be key levels to place your stops and forecast potential profit targets.
Below is an image with all three tools side by side across different markets.
Time-based stop loss strategy
This is a more discretionary stop loss strategy where the trader exits a trade after a certain period if the price action remains stagnant. For instance, you may close a trade after two hours if the market hasn’t moved substantially from your entry and wait for the next signal.
Your trading strategy or plan would have indicated to you that the price will, at some point, move against you. Thus, you could lose less, ‘break even,’ or come out with a small profit instead of waiting for the stop loss to trigger, where you lose more money.
Another example is when a trade goes against you soon after entering. Assuming you’ve seen abnormal price movements or technical or news triggers, you may decide to cut your losses at this point instead of waiting.
This strategy can be worthwhile for minimising potential losses. Yet, it may be detrimental since time isn’t always a good indication of inactivity or uncertainty.
Best practices for setting a stop-loss
By now, you should have an arsenal of stop loss strategies to explore. Ultimately, it’s a personal choice on which one should be used. It depends on your trading strategy, experience, skill and general preference. Regardless, these are the tips to remember when you use stop losses.
Avoid one-click trading
It’s simple and enticing to use one-click trading as soon as you spot a trading opportunity. Yet, it comes with massive risk, particularly in volatile markets.
A trader may not have enough time to add the stop from when they entered a trade to when the price goes against them. This is how fast price fluctuations can occur.
You’ll want to prevent any situation where you end up with a bigger floating loss than intended. The straightforward solution is to avoid one-click trading. Rather, input the stop while placing your order before it goes live.
Never fiddling with your stop
Day traders should understand that much thought goes into setting a stop loss order. Once you’ve decided on your stop loss price (what you believe is the ultimate invalidation point), it should be set in stone.
It’s a rookie mistake to widen your stop loss (leading to more losses) or tighten your stop (leading to premature stopouts) during a live position. The key is to have discipline and follow your trading plan.
Don’t be too tight
It’s better to be a little wide than a little tight. This is where an indicator like the ATR comes in handy. Most day traders should consider adding more ‘breathing space’ to their stops, especially in volatile markets. This ensures they remain in their positions for longer and, at the very least, don’t lose the trade.
Can stop-loss orders fail?
Absolutely, which can lead to more losses than planned.
They fail mainly due to slippage that happens in erratic or high market volatility. Slippage is a rare event when a position executes at a different price point than originally set, which can be favourable or unfavourable depending on the scenario.
It occurs for entries and, more pertinently, when you are automatically exiting a trade with a stop order (whether it’s at a loss or profit).
Despite the potential for unfortunate slippage, it doesn’t mean active traders should consider a mental stop. Slippage is quite rare, mainly if you use a reputable broker with access to deep liquidity.
The first method to minimise this is trading the most highly liquid instruments with smoother movements, giving you the best chance of the stop closing at the predetermined level.
Secondly, you may avoid certain market periods, like high-impact news known for slippage.
Another solution is using a broker that provides guaranteed stop loss orders (GLSOs).
As the term suggests, a GSLO is a kind of stop loss guaranteed to close your position at the intended stop loss price level, regardless of the market dynamics.
It’s a more effective risk management strategy compared to the traditional stop loss. Yet, it’s a feature available with only a handful of brokers, and a premium is attached if the GLSO is triggered.
Final thoughts
Like Bruce Kovner once said, traders sleep better using a stop loss.
Given the highly speculative and leveraged nature of most online-traded markets, few accounts can handle large floating losses for long periods.
The fact is that you will lose money when trading. Properly using a stop loss in line with your strategy and trading plan allows you to better control how much you lose over time.
Aside from understanding the different stop loss strategies, it’s also worth learning how it influences the common occurrence of liquidity grabs. Learn more about it here.
Want to dig in some more?
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