Determine A Proper Stop Loss When Day Trading

Trying to figure out the best stop loss when day trading is always a hard thing, even for more experienced traders. One thing is most certain, those traders that consistently do not use stop loss orders face almost a 100% chance of losing a significant amount of money, if not all of it. Even the prudent use of stops, if they are placed in the wrong area, will result in consistent losses no matter how good the stock idea is. Additionally, adding to positions in front of economic data to be released or other unpredictable events can assure higher odds of getting stopped out because of increased volatility post release.

The main thing to keep in mind is CURRENT MARKET CONDITIONS - I cannot stress this enough. Not what the Dow Jones Average is doing, it is what many stocks are doing overall and how they are trading. What is the general volatility level for the day, is stuff trading slow and steady or are they whipping up and down quickly on a slight move in the futures market? This makes a huge difference is not only your stop, but the risk level involved. Most people assess risk by the amount one can lose when day trading or swing trading. What almost everyone fails to consider is the odds of that loss happening.

While there is no easy formula to figure out the odds, if you watch the pattern of behavior of how similar stocks are trading, you can get a pretty good idea. If current conditions are calm, you can usually use a smaller stop amount and still have decent oddsit will not get hit. When conditions are frantic, a smaller stop is almost assured to get hit - meaning the 30c stop has a 98% chance of getting hit even on the exact same name.

The way you figure the odds in a stop happening when day trading is somewhat straightforward. Look at the average range over the last 20 minutes or so, the high to the low area of the bars. Do not pick a very calm period of time, as this calmness tends to lead to increased and unpredictable volatility. If the price action currently is very flat and calm, go back on the chart to a more volatile time of the day or prior day and then figure out the range. It does not need to be an exact amount, we are just looking for an approximation. Once you have this range, that is your maximum risk.

What the best thing to do is to try to lower the max amount to a much lower level. This can be done 2 ways. The first way is to study the pattern of trading behavior for that stock locallly when it reaches a prior high level - does it normally fade back or does it have momentum and push through? If it tends to push (last few times it reached a high turn point), then its ok to buy the stock on strength. If it tries to sell, or looks like a fade back - wait for it to push and then put your order in at 1/4 of the range computed, but lower than the high its at currently. So if the price range figured was 1.00, and the stock was at 40 now, you would put your order at 39.75 to go long. You will most likely miss some trades doing it this way, but have to ignore the urge to chase the prices. If the pattern is on a lot of names (by eyeballing) you have to be especially careful.

A second way to remove some of the risk is to split your entry order into 2 different parts. So if your trade size you want is 500 shares, just buy 200 shares now. Wait until the price moves up a decent amount, including past the point where normally they would fade a breakout, and then look to add the remainder on a small dip of 5-15 cents or so. Move your stop up .45 now (assuming you had a 1.00 stop to start) on the whole thing. The other alternative, if the market tends to fade the push moves, is to buy 200 shares now, then put the balance of your order .25 above your stop (assuming it is 1.00). The max stop remains the same on all shares. The difference here is if market conditions get poor for going long when day trading for a period of time, you are going to lose a lot more averaging when its selling because you will get filled on the add, then stopout 2 minutes later on all of it.

The easiest way around this situation is to lower your share size - when upredictability sets in, trade only 1/2 your normal size. The name of the game is preservation of capital first and foremost (hence the stops), but second its to avoid easy loss situations. While is is very difficult to actually tell that trading conditions are improving without actually trading, it is a very good idea to trade with less shares until you visibly see conditions look better over time.