When you look at your own experience in shares, it would be odd if you hadn't had at least one big loss or, at the least, a significant "lost gain". I still have a "position", if you can call it that, in a crappy little stock that went from being worth $50,000 at the time of purchase to $180,000 about a year later and is now worth just a few hundred dollars. I remember saying that if it ever got back to 9? ($180,000), I would sell it. It never did and I just hung on to the death. Long-term investment, it seems, has one major flaw: it trains you to ignore shares that fall in price.
Stop losses, or "stops", are little more than an effort to control that weakness, to cut losses while letting profits run. They are a discipline, a mechanism designed to point out, unemotionally, that a trend has moved against you. They can be used by any investor in any time frame, even by long-term value investors and the people who need them most: wealthy people with big individual stock positions.
Stops can be set in many different ways. This week, we'll look at technical or mathematical stops. Next week, we'll look at more subjective stop losses.
Most technical stops have variables, or inputs that vary depending on the kind of sharemarket operator. Traders use tighter stop losses and use shorter periods for their data. Long-term investors will use wider stops and longer, traditionally weekly, data. Most are used in combination with each other. We cannot possibly explain stop losses in 700 words, so here is a taste. The traditional stops in short form:
A dollar-based stop loss and profit stop
I'll sell when I've lost $1000 I'll sell when I'm up $1000. A bit arbitrary but easy to measure and understand.
A set-percentage stop loss
If a stock falls a certain percentage from the buy price, sell it. Pretty obvious. The longer the time frame, the bigger the loss tolerated. Investors might use 10 per cent active traders use less.
A trailing stop loss
The same as a set-percentage stop loss but the highest price reached since buying the stock is used as a reference point, rather than the buy price. This is perhaps the most commonly used stop-loss mechanism but takes a bit of work to monitor. The beauty of a trailing stop loss is that it locks in profits as well as stop losses and locks in a profit when a share price has risen enough.
A chart-based stop loss
There are lots of these. You sell when certain technical analysis-based indicators are triggered. An obvious one would be when a support and resistance level is broken - when a stock falls below support. There are a host of well-developed technical signals designed to indicate when to sell. Most traders combine a number of them.
A volatility-based stop loss
This is what we use: stop losses based on a measure of volatility, such as selling when the stock falls to twice its average true range. Lost you there, no doubt, but the basic message is that stop losses are wider on more volatile stocks and tighter on boring stocks.
A percentage of capital stop loss I'll sell when I've lost 2 per cent of my total capital in this one stock. This is a technique used by traders who practise risk management on a more scientific level. A focus on "capital at risk" is used to do more than set a stop loss: it dictates the size of the positions an investor is prepared to take (position sizing) and the number of trades that can be taken.
We have only scratched the surface. The basic message on stop losses is that something, anything, is better than nothing. Using stop losses means you have a plan that means a "certainty of action", which means knowing what you are going to do after the purchase. There is tremendous value in that, tremendous peace of mind and it's so much better than making it up as you go along.
Frequently Asked Questions about this Article…
What is a stop loss and why should everyday investors use stop losses?
A stop loss (or “stop”) is a pre-set rule that automatically signals or triggers a sale when a share moves against you. Stop losses help investors cut losses while letting profits run, impose discipline, remove emotional decision-making, and give you a “certainty of action” and peace of mind after you buy a stock.
Who should use stop loss orders — are they only for traders or also for long-term investors?
Stop losses can be used by any investor in any time frame. Traders tend to use tighter stops and shorter data periods, while long-term investors use wider stops and longer (often weekly) data. Even long-term value investors and wealthy people with large individual stock positions benefit from using stops.
What are the common technical types of stop loss orders I should know about?
Common technical stops include: dollar-based stops (sell after a fixed dollar loss or profit), set-percentage stops (sell if a stock falls a certain percent from purchase), trailing stops (use the highest price reached since buying as the reference), chart-based stops (sell when technical indicators or support levels are broken), volatility-based stops (wider on volatile stocks, e.g. tied to average true range), and percentage-of-capital stops (sell when a position has lost a set share of your total capital).
How does a trailing stop loss work and what are its benefits?
A trailing stop loss moves the stop level up as a stock reaches higher prices by referencing the highest price since purchase rather than the original buy price. Its benefit is that it locks in gains as the share rises while still protecting against reversals, though it requires monitoring or an automated order to manage.
What is a volatility-based stop loss and how does average true range (ATR) fit in?
A volatility-based stop sets stop levels according to a stock’s volatility — wider for more volatile shares and tighter for low-volatility ones. One common approach is to sell when the stock falls to twice its average true range (ATR), which uses recent price volatility to size the stop appropriately.
How should I decide how wide or tight to set my stop loss?
Stop width depends on your time frame, the stock’s volatility and your risk tolerance. Long-term investors generally allow bigger moves (for example, some investors use around 10% while active traders use less), and volatility-based methods widen stops for jumpy stocks. The right stop balances avoiding needless exits with protecting capital.
What is a percentage-of-capital stop loss and how does it help with risk management?
A percentage-of-capital stop sells a holding when it has cost you a set percentage of your total capital (for example, 2%). This technique ties stop decisions to overall portfolio risk, informs position sizing and how many trades you can take, and is used by traders who want a more scientific approach to risk management.
Should I combine different stop loss methods, and is something better than nothing?
Yes — many investors combine stops (for example, a volatility-based stop plus a chart-based trigger) to get more reliable signals. The article’s basic message is that having any stop loss plan is better than none: something, anything, is preferable because it gives you an actionable plan instead of making it up as you go along.
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