The stop-loss concept is one of the most necessary, but unfortunately, also one of the most overstated terms in the investment world. These conflicting drivers make stop-loss a vital yet also tricky checklist item in trading.
Determining a stop-loss level that is too large is dangerous and potentially makes the trader lose a lot on a bad call. However, even worse happens when the trader accurately positions his/her trade in the right direction with a very tight stop-loss and gets stopped before the instrument makes the expected move to the right direction. Especially in instruments that demonstrate high volatility by their nature (e.g., high beta stocks, commodities, and f/x instruments) placing a small stop would almost certainly end-up in a loss. The market is full of fake rallies, false breaks, and timeless surprises that can confuse a disciplined stop-loss approach easily.
Investors and traders use different stop-loss methodologies when entering trades and managing their portfolios. These include technical levels (e.g., major support levels, double-bottoms etc.), % or absolute loss levels, and others. Unless you are a professional trader with substantial trading experience, we would not recommend very tight stop-losses that in series can significantly harm your portfolio balances. This is especially important when the markets start trading sideways. In those cases doing nothing and waiting for confirmations in the market become the wisest move.
Our Stock Arbitrage Trader app uses an unconventional stop-loss algorithm that is based on a trailing statistical analysis. Based on this complicated mathematical analysis, the app uses a stop-loss determined and dynamically changed (trailing) for every stock’s standard deviation and variance characteristics. If the price reaches that particular stop level, the signal changes to hold or reverses from buy to sell (or vice versa). However, in our app – as can be seen from P/L levels – these stop-loss levels are not extremely small. Our clients should also note that in very volatile tickers (e.g., FSLR) the actual signal reversal mostly occurs before a stop-loss is reached. In other words, our clients will be seeing stop-losses very rarely in our app. On the other hand, the model would be accurately reversing trades before these sharp moves take place in the price.
How do you manage your stop-loss level? Let us know in the comments section below.
You can download Stock Arbitrage Trader for your iPhone and iPad via the iTunes App Store.
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Psychological Factors Affecting Short Term Stock Trading Part 1 and Part 2