From the July 01, 2012 issue of Futures Magazine • Subscribe!

Controlling losses: Stop placement techniques

Percentages

Stop loss levels also can be based on a percentage of the purchase price or a percentage of trading capital. The actual percentages vary and, like dollar-based values, should be modified according to trading style, risk tolerance and the type of strategy. 

Percentage of purchase price

Stops based on the purchase price typically range between 5% and 15%. Short-term traders may gravitate toward the lower end of the range, while longer-term investors might use an even larger percentage to accommodate larger market movements and trends. 

Percentage of trading capital

The general rule of thumb is that you never should risk more than 2% of trading capital on any single trade. If a trader had a $100,000 trading account, for example, he or she would not risk more than $2,000 on any single trade; with a $30,000 account, the maximum risk would be $600, and so forth.  

Percentages are useful because they vary according to the market itself or the trader’s equity. However, setting the percentage properly is key. Again, historical testing can be used to determine optimal percentages on past data.

Technical indicators

Technical indicators are another popular method of determining stop loss levels. Because technical indicators are based on current and past price data, these tools can provide dynamic stop loss levels that reflect both the individual trading instrument and prevailing market conditions. Popular indicators for setting stop losses include moving averages, average true range (ATR), Fibonacci retracements and support and resistance zones. All of these tools are available in modern financial charting software packages.

The ATR indicator, for example, measures volatility over a specified time period. A higher ATR indicates a more volatile market, suggesting that the instrument could move in a wider range. Conversely, lower ATR values denote less volatile conditions and may predict times when price will move in a more restricted range. The ATR typically calculates the average using 14 periods, but can be calibrated to a trader’s and his system’s preference. “Volatile stops” (right) shows examples of how various types of traders might apply the ATR for determining stop loss levels.

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