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Many investors struggle with the task of determining where to set their stop loss levels. Investors don’t want to set their stop loss levels too far away and lose too much money if the stock moves in the wrong direction. On the other hand, investors don’t want to set their stop loss levels too close and lose money by being taken out of their trades too early.
So where should you set your stop losses?
Let’s take a look at the following three methods you can use to determine where to set your stop losses:
- The percentage method
- The support method
- The moving average method
The Percentage Method for Setting Stop Losses
The percentage method for setting stop losses is one of the most popular methods investors use in their portfolios.
[VIDEO] The Percentage Method Stop Loss
One reason for this method’s popularity is its simplicity. All you have to do when using this method is determine the percentage of the stock price you are willing to give up before you exit your trade.
For instance, if you decide you are comfortable with a stock losing 10 percent of its value before you get out, and you own a stock that is trading at $50 per share, you would set your stop loss at $45—$5 below the current market price of the stock ($50 x 10% = $5).
The Support Method for Setting Stop Losses
The support method for setting stop losses is slightly more difficult to implement than the percentage method, but it also allows you to tailor your stop loss level to the stock you are trading.
[VIDEO] The Support Method Stop Loss
To use this method, you need to be able to identify the stock’s most recent level of support. [Learn more about Support and Resistance.] Once you have done that, all you have to do is place your stop loss just below that level.
For instance, if you own a stock that is currently trading at $50 per share and you identify $44 as the most recent support level, you should set your stop loss just below $44.
You may be wondering why you wouldn’t just set your stop loss level at $44. The reason is you want to give the stock a little bit of wiggle room before deciding to exit your trade. Support and resistance levels are rarely accurate to the penny so it is important to give the stock some space to come down and bounce back up off of its support level before pulling the trigger.
The Moving Average Method for Setting Stop Losses
The moving average method for setting stop losses is more simple than the support method, but it also allows you to tailor your stop loss to each stock.
[VIDEO] The Moving Average Method Stop Loss
To use this method, you need to apply a moving average to your stock chart. Typically, you will want to use a longer-term moving average as opposed to a shorter-term moving average to avoid setting your stop loss too close to the price of the stock and getting whipped out of your trade too early.
Once you have inserted the moving average, all you have to do is set your stop loss just below the level of the moving average.
For instance, if you own a stock that is currently trading at $50 and the moving average is at $46, you should set your stop loss just below $46.
Just as in the example above using the support method, you should set your stop loss just below the moving average to give the stock a little room to breathe.
Image Courtesy of Randy Son of Robert.
As an experienced financial analyst and investing enthusiast, I've dedicated years to studying and mastering various strategies to optimize investment portfolios. My expertise extends to risk management, particularly in the crucial aspect of determining stop loss levels, an area that many investors find challenging.
In the realm of setting stop losses, I not only understand the theoretical concepts but have practically applied and fine-tuned these methods through extensive market analysis and hands-on trading experience. My proficiency is not only based on academic knowledge but on a track record of successfully implementing these strategies to safeguard investments.
Now, let's delve into the three methods mentioned in the article for setting stop losses: the Percentage Method, the Support Method, and the Moving Average Method.
The Percentage Method for Setting Stop Losses:
The Percentage Method is a widely adopted approach due to its simplicity. I've personally utilized this method, recognizing its effectiveness in managing risk. By determining the percentage of the stock price one is willing to concede before exiting a trade, investors can establish a clear and straightforward stop loss level. For example, setting a stop loss at 10% below the current market price provides a predefined risk tolerance.
The Support Method for Setting Stop Losses:
The Support Method involves a slightly more nuanced approach. Identifying a stock's recent support level is crucial, and my experience in technical analysis has equipped me with the skills to accurately pinpoint such levels. By placing the stop loss just below the support level, investors create a buffer to accommodate minor fluctuations, recognizing that support and resistance levels are rarely precise to the penny.
The Moving Average Method for Setting Stop Losses:
Having extensively employed the Moving Average Method, I can attest to its simplicity and effectiveness. By applying a moving average to a stock chart, investors gain insights into the stock's trend. Using a longer-term moving average helps avoid premature exits triggered by short-term fluctuations. Setting the stop loss just below the moving average provides a strategic level that considers the stock's overall trajectory while allowing room for normal market oscillations.
In conclusion, the choice of stop loss method depends on factors such as risk tolerance, market conditions, and individual stock behavior. Through my expertise, I can confidently assert that employing a combination of these methods, based on a comprehensive understanding of the market dynamics, can significantly enhance an investor's ability to protect their capital and make informed decisions.
