Risk management
A stop-loss order is an instruction to sell a security when it reaches a specific price. It exists for one reason: to limit your loss on a trade that is not working. Every professional trader uses them. Most losing traders either do not use them or use them incorrectly.
Without a stop-loss, you are relying on willpower to exit a losing trade. Studies consistently show that traders hold losers too long and sell winners too early. A stop-loss removes emotion from the equation by automating your exit at a predetermined level.
A stop-loss also makes position sizing possible. You cannot calculate how many shares to buy if you do not know where you will get out. The stop-loss defines your risk, and your risk defines your position size.
You set the stop a fixed percentage below your entry. For example, a 5% stop on a $100 stock triggers at $95. This is the simplest method but ignores market structure entirely. A 5% stop might be too tight for a volatile stock and too wide for a stable one.
You decide the maximum dollar amount you are willing to lose per share. If you buy at $80 and are willing to lose $4 per share, your stop goes at $76. This method works well with the position sizing formula but, like percentage stops, does not account for where the stock is likely to find support.
You place the stop just below a key support level, such as a recent swing low, a moving average, or a trendline. This is the most logical approach because it lets the market structure define your risk. If the support breaks, your thesis is wrong, and the stop gets you out.
For example, if a stock is trading at $52 and has strong support at $49, placing your stop at $48.50 (just below support) gives the trade room to breathe while protecting you if the level fails.
The Average True Range (ATR) measures a stock's typical daily price movement. An ATR-based stop is placed a multiple of the ATR below your entry. A common setting is 1.5x to 2x ATR.
If a stock has an ATR of $3 and you use a 2x ATR stop, your stop is $6 below your entry. This method automatically adjusts for volatility: wide stops for volatile stocks, tight stops for calm ones. Many professional trading systems use ATR-based stops exclusively.
Use the Stop-Loss Calculator to compute the right level for your trade.
A trailing stop moves up with the price but never moves down. It locks in profits as the trade moves in your favor. You can trail by a fixed dollar amount, a percentage, or an ATR multiple.
For example, you buy at $50 with a $3 trailing stop. When the stock reaches $55, your stop automatically moves to $52. If it reaches $60, your stop is at $57. If the stock then drops from $60 to $57, you are stopped out with a $7 profit instead of the original $3 loss.
Stop types at a glance.
| Stop type | Best for | Weakness |
|---|---|---|
| Percentage | Beginners, simplicity | Ignores volatility and structure |
| Dollar | Position sizing calculations | Ignores chart levels |
| Support level | Swing traders, chart readers | Requires technical analysis skill |
| ATR-based | Systematic traders, all markets | Requires ATR data access |
| Trailing | Trend-following, locking profits | Can exit too early in choppy markets |
A stop that is too close to your entry will get triggered by normal price fluctuations. You get stopped out, the stock reverses, and it hits your original target without you. If a stock moves $2 on an average day, a $0.50 stop guarantees frequent stop-outs.
A stop that is too far away protects you from stop-outs but exposes you to large losses. If your stop is $10 below your entry on a $50 stock, you are risking 20% on a single trade. Use the Position Size Calculator to check that the resulting position size is reasonable.
This is the most destructive mistake. The stock drops toward your stop, you panic, and you move the stop lower to give it more room. Then it drops further, and you move it again. You have turned a small planned loss into a large unplanned one. Never move a stop-loss in the direction of your loss.
No stop means unlimited risk. You might plan to exit mentally, but when the stock drops 15%, you will convince yourself it will bounce. Mental stops do not work because they rely on the same emotions that caused you to hold the loser in the first place.
A 5% stop on a stable utility stock is reasonable. A 5% stop on a biotech stock is almost certainly too tight. Match your stop method to the stock's volatility. ATR-based stops handle this automatically.
Your stop-loss is not an afterthought. It should be the first thing you determine when evaluating a trade. Before you decide whether to buy, figure out where your stop would go. Then calculate the risk-reward ratio. If the ratio is not at least 1:2, skip the trade.
This approach works with any pattern. Whether you are trading a head and shoulders breakdown or a breakout above resistance, the stop defines your risk, and the risk defines whether the trade is worth taking.
Calculate your stop level now with the Stop-Loss Calculator.
Educational content only. Not investment advice. Trading involves substantial risk of loss.