Stop loss orders: where to set them and why
Learning objectives
Explain what a stop loss does and why it triggers an exit rather than guaranteeing a price
Place a stop at the level that invalidates your trade idea, rather than at the loss you'd prefer
Recognise the three placement errors that cause otherwise sound trades to fail
What is a stop loss?
A stop loss is an instruction you leave with your broker: if the price reaches this level, close my position. It's the difference between a loss you chose and a loss the market chose for you.
It's also the most misunderstood order type on the platform, in two specific ways.
What a stop actually promises
A standard stop loss is a trigger, not a guaranteed price.
When the market reaches your stop level, the order becomes a market order and fills at the best price available at that moment. Usually that's very close to your level. Sometimes it isn't.
Two situations cause the gap:
Slippage. In fast-moving conditions, particularly around economic releases, prices can move several pips between your stop triggering and the order filling. You get out, but not exactly where you asked.
Gapping. If the market closes and reopens at a different price, your stop was never available to trade at. A stock CFD stopped at $170 can fill at $158 if the company reported bad earnings overnight. Lesson D1.3 covered why this happens to some instruments and not others.
So a stop caps the loss you intended, most of the time, and does not cap it absolutely. Some brokers offer guaranteed stops that do fill at your level, usually for an additional cost. Check what your account offers before you need it.
None of this is an argument against using stops. It's an argument against believing they're a force field.
Where the stop belongs
Here's the question most beginners ask: how much am I willing to lose on this trade?
Here's the question that produces good stops: at what price is my reason for this trade wrong?
Those produce very different answers, and only the second one is useful.
Every trade rests on a reason. The price broke above a level and you expect it to continue. A trend has been intact for two weeks and you expect it to persist. Support has held three times and you expect it to hold again.
Each of those reasons has a price at which it stops being true. If support has held three times and the price closes well below it, the reason for your trade has gone. That price is your stop. Not because of what it costs you, but because you no longer have a trade.
This is called the invalidation level, and putting your stop there does something valuable: it means every stop-out tells you something. You weren't unlucky, you were wrong, and you found out at the cheapest available moment.
Why "how much I can afford" is the wrong input
If you set your stop based on the loss you're comfortable with, you've placed it at a price that means nothing to the market.
A $20 tolerance on a $500 account might put your stop fifteen pips away on a pair that routinely moves eighty pips in a session. The market doesn't know or care that fifteen pips is your comfort zone. It will move through that level for entirely ordinary reasons and then continue in the direction you originally expected, and you'll be watching from outside the trade.
The comfort figure isn't irrelevant. It just belongs somewhere else in the process. Stop distance comes from the chart. Then, given that distance, position size is adjusted so the loss is affordable. That's lesson 2, and it's the reason these two lessons are next to each other.
Three common mistakes
Too tight. The most common error by a distance. A stop set very close to entry gets triggered by routine noise, and as lesson 4 in the Discover path explained, it can also be triggered by the spread widening rather than by any real move. A stop needs enough room to survive normal fluctuation, or you'll be right about the direction and lose anyway.
On the obvious number. Round numbers and the exact high or low of an obvious range attract a concentration of stops, which makes them a natural place for price to reach before reversing. Placing your stop just beyond the obvious level, rather than exactly on it, costs a little more distance and avoids a lot of avoidable exits.
Widened after entry. Covered in lesson 1, and worth repeating because it's the one that ends accounts. The only acceptable direction to move a stop is the one that reduces your risk. Moving it further away converts a defined loss into an undefined one, at precisely the moment your judgement is worst.
What about trailing stops?
A trailing stop follows the price at a set distance as a trade moves in your favour, and stays put when it moves against you. Used well, it locks in progress on a trend without you watching.
Used badly, it's a way of getting stopped out of good trades early, because the trailing distance is set tighter than the instrument's normal fluctuation. The same rule applies: the distance comes from what the market does, not from what you'd like to keep.
A short checklist
Before you place a trade, you should be able to answer all three:
- What's my reason for this trade?
- At what price is that reason no longer true?
- Is my stop at that price, with a little room beyond the obvious level?
If you can't answer question one, questions two and three are unanswerable, and you don't have a trade. You have a guess with an order attached.
Key takeaways
A standard stop triggers an exit at the best available price, and slippage or gapping means the fill can be worse than the level you set
Place the stop where your reason for the trade stops being true, not at the loss you'd prefer to take
Stops that are too tight, or sitting exactly on an obvious level, get triggered by ordinary movement rather than by being wrong
The only direction a stop should ever move is the one that reduces your risk