Trading Rule #4 - Stop Loss Exit

Before you enter any trade, you need to define the price in which you will get out if the trade does not go as originally planned.  You need to accept the reality that with trend-following trading you will be wrong more often than you are right.  Most successful trend-following trading strategies have between 30-50% successful trades.  Even with a 30% success rate, you can be a profitable trader as long as you strictly follow the trader’s mantra of “cut your losses short and let your profits run.” 

There are many ways to determine your stop loss exit.  Like the rest of your trading system, it must be something you are comfortable with and clearly understand the logic behind it.  You can consider using a percentage stop loss (i.e., sell if stock price drops x% below purchase price) or a stop slightly below the breakout price, a specific moving average, or other price resistance level. Many trend following traders use a multiple of the 20 period Average True Range (ATR) to determine the price where to place their stop loss.  A 20 period ATR is the average high to low price range of the last 20 trading days (1 month). The ATR is usually multiplied by a factor (i.e., 2x -5x) to give the price some time to stabilize before resuming the prevailing trend. The benefit of using an ATR stop loss is that when you combine it with money management techniques discussed in the next section, it allows you to buy more shares of less volatile stocks and fewer shares of more volatile stocks.  Whatever stop loss you decide on; you must ensure that you have an active sell stop order placed for every open position you have in your portfolio.   This is the only way you can control your downside risk.  If your stop is hit and the stock still meets your buy criteria, you can, and should, buy the same stock again.

In the next lesson we will develop Trading Rule #5 - Money Management.

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