A stop loss is a specific price or price point on a chart where, if the stock crossed that price, you would want to close the trade without suffering further loss. It’s common for most traders to set their stop loss based on some point on the chart, but new traders in particular should set their stop loss based on the volatility of the stock.
When setting a stop loss based off the chart, the stop is set using one of the following reasons:
- A specific dollar amount below the candles
- The low of day (LOD) or other intraday low
- The low of past three to five candles
- The low of the channel
- A Moving Average or VWAP
A specific dollar amount should never be used, unless it is a previous low set sometime in the past. The LOD or some other intraday low is more widely used, but it too often fails as stocks form multiple lower lows before breaking new highs. The low of the past three to five candles is used by traders playing a bull flag or testing a breakout, but it often fails because the price is highly volatile in shorter timeframes. The low of a channel is also used, but it fails when market makers test bottoms during their manipulation phase. Probably the best way to set a stop loss is by using a moving average and the VWAP, but a stock can have a sudden drop below the VWAP and dip right through one or two moving averages before finding its support.
The stop loss techniques I just mentioned above suffer from one major flaw – they are all within market noise and susceptible to market volatility. A person new to day trading will want to have a stop loss outside the noise of the market, where prices are least likely to hit. In order to trade outside of the noise, the new day trader must know the volatility of a stock. Fortunately, there’s an indicator that measures volatility, which is the Average True Range (ATR).
Volatility is measured by the spread of a candle, or the difference between the high and low of the candle. The ATR is the average of this spread over a period of X number of candles. By default, the ATR indicator’s input is set to 14 RMA, which is designed to smoothen out the indicator line. You want the indicator line to reflect the current level of volatility, so use a 9 EMA as the input.
Set your stop loss based on the following:
Stop Loss = ENTRY – (ATR * 2)
The ENTRY is the price you bought (or expect to buy) the stock and the ATR is the value of the previous candle. The (ATR * 2) is an additional buffer to help move your stop loss below the market noise.