Deviation based stop loss overview

Standard deviation based stop loss

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These traders consider the market movement to be normally distributed, as on a bell curve. To use a stop loss based on a standard deviation, we need a reference point, such as a moving average. Many indicators have been developed for this purpose. The most widely used are Bollinger bands, which plot a series of standard deviations around a moving average.

Here is a chart of the ES (S&P500) with Bollinger Bands. I have set it up so that the bands are plotted two standard deviations away from a simple 20-day moving average. Based on your trading philosophy, trend following or reversion to the mean (both are applicable), a stock touching its Bollinger Bands may mean it is overextended or it may be the sign of an impulse move that may start a new trend.

Now let's look at a longer-term trading example. Let's say you want to go long the S&P500 because you believe the downtrend will continue for good reason. You can see that this is a multi-hour short trade, so your look-back period should reflect this. Perhaps we use the 50-day simple moving average as your reference point, with the lower band (two standard deviations from the 50SMA) being your stop loss.

We can see that the upper band is at USD 3260, which will be our stop loss, USD 45 away from the current price, which will be our long entry. If we use the same risk parameters as in the last example, we are risking 1% of our $100,000 account, which is $1,000.

Again, we will simply divide $1,000 by $45, which gives us 22 shares.

Key market levels

Some traders use levels such as support, resistance or indicator levels to place their stops. These types of trades can sometimes offer asymmetrical risk/return profiles. In a scenario where you are bullish on a stock that is very close to a key support level, you can bet on rising prices with a small amount of risk because you are using the support level as a stop loss.

One potential challenge with this type of stop placement is market noise. Many of what traders think are support or resistance levels are simply levels at which the market happened to trade at several points in time. An actual support or resistance level is a point where the balance of supply and demand is upset and the market moves away from the levels. This is easier said than done, but it can be difficult to distinguish between an "accidental" support level and an actual support level when demand is outsized.

The idea is the same, use the level to place your stop and then use the stop in mt4 to determine your position size based on your risk parameters.

Here is an example of the stock of ADP. There appears to be a support level around $127, marked by the red line on the chart.

If we use the $127 support level as our stop loss and enter at the current price of $130.95, we get a wide stop loss of $3.95. If we use the same risk parameters as before and risk 1% of our $100,000 account, we have a risk of $1,000 on this trade. If we divide our risk of $1,000 by our stop loss width of $3.95, we arrive at 253 shares.

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Percentage loss in the account

This method is mainly used by longer-term swing traders. It's very simple: if the stock falls X% below our entry price, we sell. It sounds less good than the above methods, which involve either price-action analysis or a quantitative measure of market volatility, but the method has been used successfully by some of the best-known stock traders.

William O'Neil used the percentage loss method to great effect in his CANSLIM method, as did his equally successful prodigy David Ryan.

My conclusion: the right position size promises more success in day trading

It is not so much fun to talk about position sizes. It is rare for two traders to go out for a drink and have a long conversation about position sizing and risk management. And this is exactly why so many traders fail, because they only spend time on the fun parts of trading like price action analysis and creating stock scans.


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