Different Stop-loss Methods-Their Advantages and Disadvantages

I've heard many interesting analogies about stop- loss, here I am going to share two with you:

1. Trading without stop loss is like driving a car without breaks, you can always set out, but there will be problems sooner or later.
2. Someone crossed the road with his/her eyes closed and was not killed, so he/she plans to cross the road without opening eyes for the rest of life.

The speculative market is dominated by random reinforcement, where you may lose money when you do the right thing, while making a profit when you do something wrong. People who trade without stop loss are like those who cross the road with their eyes closed, some are lucky for the time being, some people are killed by cars and some are about to be killed.

The unwillingness to stop loss comes from the deep-rooted human characters:

• Aversion to loss.
• Aversion to failure.
• Overwhelming cost effect.

It is very hard and painful for those with aversion to loss and failure to stop loss when their stocks in a loss, for it will make the loss become real account deficit. With overwhelming cost effect, their next decision in the market revolves around: how to prevent the locked-up stocks from becoming real account losses, and they are convinced that they will recover the profit as long as not sell at a loss.

These three human characteristics make a large number of speculators forget the original intention of entering the market, which is to make money (turn 100,000 to 200,000), instead of calculating whether the loss can be recovered every day (100,000 to 100,000).

Recently I’ve been playing an iOS game called Space Marshals, in which the player has to kill dozens of creeps in each level before getting to the Boss. If you get killed in the process, the entire level needs to be replayed (no matter how many high-value enemies you’ve killed before), so this requires us to focus on defense, putting attack the second place, and kill all of them little by little (covering with stones, sandbags, etc., and then then choose the attack plan and route). In fact, any good offensive strategy is based on great defensive. For speculative trading, before any transaction, you should first set a stop loss level, and then open a position.

There are three stop loss methods based on mainstream technical analysis：

1. Percentage stop loss.

Taking 2% for example, if you buy 10,000 shares of 50 yuan with the total price of 500,000, then the risk is 2% of 500,000, and that will be 1,0000. That is to say, stop loss will work when the loss reaches 1,0000.

As the most popular method currently, percentage stop loss is probably used by your parents in stock market.

Advantage: simplicity. It is easy to understand, and you can even teach your parents if they invest in stock market. 

Disadvantage: great randomness with no scientific basis for stop loss ratio.

2. Support and resistance stop loss.

Set up a long stop loss in the support area and a short one in the resistance area. acting as the support area and resistance area of the technical analysis patterns are: upper and lower edge of the market, peaks and troughs, trend line, double tops and bottoms, head and shoulder bottom and head and shoulder top.

Taking the price range of the original resistance area is 48 yuan to 50 yuan as an example. Do long for 10,000 shares when the price exceeds50 yuan with stop loss placed at 48 yuan or below. Then the risk is: 2 * 10000/10000 * 50 = 4%.

Supporting resistance is the mainstream method of technical analysis stop loss. The support area and resistance area mean that the price is difficult to break through, where the probability of reversal is high, even if the market price is breached, it is still a psychological support.

Advantage: high reversal probability. It is a psychological support even if the price is breached.

Disadvantage: unable to limit single loss amount.

Eg.1 stop loss at the upper and lower ends of the whole market.

Eg. 2 Stop- loss by reverse key line.

The lowest price of the pin bar is a strong resistance zone. We can see from the formation of the pin bar: at first the price opened at a higher level, then it fell to the lowest point for a period of time, and it rebounded completely, closing at the highest or nearly highest level, which means that in the lowest price area, there is strong resistance which is not easy to be broken, especially the long under hachure.

Eg. 3 Double tops and bottoms stop- loss.

The red line represents the neckline, and we can set the stop- loss below it or the right side of bottom.

Eg. 4 Trend line stop loss.

 Stop- loss can be set both above the trend line.

3. Stop- loss method combining percentage stop loss and support resistance (fund management)

This means is the combination of method 1 and 2. For example, if the risk is 2% with the stop loss at 48 yuan, than we can figure out the specific opening positions by backward induction (let’s say the capital is a million) : 1000000*2%/2=10000 shares.

This stop loss approach is essentially an evolution of method 2, which simply limits the risk of each opening to a fixed value.

Advantage: the value of loss can be fixed.

Disadvantage: only for those skilled in technical analysis.

Finally, pay attention that any specific stop- loss method must be combined with a specific trading system. A life without stop loss or making stop loss blindly are all failures, just like a stop loss without a trading system, which is invalid and meaningless. If you have a trading system based on positive expectations, then stop loss is the cost you pay for using this system. However, if your system is negatively expected, then stop loss can only speed up the process of bankruptcy.

#trading##Knowledge#