In momentum stock trading or any other method of day trading, a trader needs a way to minimize the risk of losing trades. The use of stop losses is critical to a trader's capital preservation in that stop losses limit the magnitude of a losing trade. Simply put, a stop loss is a pre-designated price point at which a trader chooses to exit a trade with a minimal loss.
Why Use Stop Losses?
There are 2 main reasons to use stop losses.
First, setting a stop loss helps to manage your trading risk and preserve your capital for future trades. The reality for day traders is that not every trade is a winning trade. Stop losses allow for a small movement in price going against you, but caps the amount of negative movement you are willing to absorb. By exiting a trade that is going against you with only a small loss, you will have preserved your trading capital for future trades.
Secondly, stop losses help eliminate emotional trading. As a trader, you need to guard against staying in a trade too long while hoping for a turnaround. Set correctly, your stop loss will allow for small fluctuations in price but protect you from more powerful momentum going against you.
How to Set an Effective Stop Loss
Let's use the following example: Assume my research shows that Stock XYZ is poised to run up. It closed the previous day at $41.53, with a daily high for that day of $41.95. I typically set an entry point at least $0.10 higher than the previous day's high, so in this case my entry point might be $42.05. Using a reward to risk ratio of 2:1, I would place a stop loss at $41.75 and an exit price of $42.65. This trading plan provides a potential upside gain of $0.60 and minimizes any loss to $0.30.
When setting stop losses, remember to consider a stock's recent resistance levels as well as a stock's recent trading range.
Trailing Stops - Adjusting Stop Losses Within a Winning Trade
Experienced day traders have found that approximately 1 in 10 trades exceeds expectations, i.e. the stock's momentum carries the price beyond the targeted exit price. When this happens, I recommend using trailing stops. In the above example, let's say that Stock XYZ exceeded our expectations, going beyond $42.65. In this case, I would adjust my stop loss up to $42.65 to lock in the first $0.60 of profit and keep adjusting the stop loss upward in $0.10 or $0.15 increments to "trail" the upward momentum. Setting trailing stops is like pocketing winnings at a black jack table. It takes some of your winnings off the table, ensuring that you walk away with a profit.
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Len Ksobiech
AM Trades Inc
Daily strategies for the morning stock trader.
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