Your first responsibility as a trader should be to protect your capital. The best way to do this is by ensuring you establish proper stop-loss placement as part of your risk management.

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Nobody is arguing you don’t know about stop-loss orders. Most traders do.

What seems to be a challenge and often confusing to most traders is knowing where to put their stop-loss orders.

Your stop should be at the right distance to ensure you stay long enough in a trade for the price to move in your direction.

Unfortunately, there is no straightforward way to do this.

In this article, we’ll look at the best places to put stop-loss orders. But before we do that, here are some tips to help you make better trades in the future.

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1. Place Your Stop-loss Where Your Trade Idea Is Invalidated

The primary principle when deciding where to place your stop-loss should be “always place a stop-loss order at a point where your trade idea is invalidated.” This means that if you’re in a trade, your stop-loss should be set at a level where continuing to hold the position would no longer make sense if the price reaches it.

For example, if you buy at a support level hoping that the price will bounce upward from that point, if the price breaks the resistance and moves downward, it doesn’t make sense to continue holding your position. Your trade idea/analysis has been invalidated.

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2. Align Stop-loss with Your Trading Strategy

Your trading strategy plays a critical role in how you place your stop-loss. Different strategies require different approaches to stop-loss placement. For example:

• Scalpers and day traders hold positions for a very short time. For that reason, they can use much tighter stop-losses, especially because they trade lower timeframes. This minimises their exposure to overnight or unexpected market events.
• On the other hand, swing traders hold trades for days or even weeks. Therefore, they need more flexibility in their stop-loss placements, which is why a slightly wider stop can allow their trades to play out over a longer period.

Regardless of your strategy, ensure your stop-loss placement works with your risk-reward ratio. For example, if you aim for a 3:1 reward-to-risk ratio, your stop-loss should allow for a reasonable profit target without being too tight or too wide.

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3. Avoid Placing Stops at Obvious Price Levels

Many traders make the mistake of placing their stop-losses at obvious price levels, such as round numbers or key support and resistance zones. Unfortunately, institutional traders, market makers, or even algorithms often target these levels, triggering your stop-loss just before the market reverses in your favour.

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4. Always Give Your Stop-loss a Breathing Room

One common mistake traders make is setting their stop-loss too tight without giving the trade any breathing room. This can expose your trade to stop hunts, a phenomenon where the market briefly sweeps through levels where stop orders are clustered, triggering them before continuing in the intended direction.

As mentioned, large institutional players and algorithms often target key stop levels, like round numbers or key support and resistance zones. Therefore, when you place stop-loss right at these levels, you risk being stopped out just as the market makes its move.

To avoid this, place your stop just outside the typical noise to prevent getting caught in these stop hunts, which often only serve to clear out stops before resuming the original trend

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5. Use Trailing Stop-losses

Once a trade moves in your favour, you don’t want to leave profits on the table. A trailing stop automatically moves your stop-loss level as the price of the asset increases, maintaining a specific percentage or dollar amount distance from the current price. This helps you protect profits while avoiding losing them due to sudden market reversals.

You should know however that trailing stops can be tricky. Trailing too close can lead to you being stopped and the market continues in your predicted direction.

A common practice among scalpers and day traders is to manually move their stop orders to break even when the price forms a new high or low. This way, their trade would run risk-free. Even if the market reverses it won’t result in a loss.

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The Best Types of Stop-Loss Orders

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Understanding the different types of stop-loss orders can help traders manage risk effectively. Here are four commonly used stop-loss types:‍

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1. Percentage Stop

The percentage stop is a straightforward method where traders risk a fixed percentage of their trading capital on each trade. A common guideline is to risk no more than 2%. This approach helps protect your capital but may ignore important market conditions and trade setups.

For instance, consider Tom, a swing trader with a $200 account. He targets a trade with a potential profit of 100 pips, risking 50 pips according to his analysis. Following the 2% rule, Tom would risk only $4 on the trade. However, risking $5 for a stop-loss placed 50 pips away would align better with his trade idea. This flexibility allows Tom to avoid being stopped out prematurely while still giving the trade room to succeed.

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2. Volatility Stop

Setting a stop-loss based on market volatility is another effective method. This approach considers historical price movements to gauge a safe distance for your stop-loss. Here are some indicators to help you with that:

• Bollinger Bands

Useful for traders operating within a price range. You account for normal price fluctuations by setting your stop-loss outside the bands, allowing for potential reversals.

• Using the Average True Range (ATR)

The ATR measures price movement over time. This provides a solid foundation for determining stop-loss distance. You can use the ATR value to set stop-loss orders according to volatility. For example, a swing trader might set a stop-loss equal to the ATR value at their entry point, while a position trader could multiply the ATR by 3 for a more generous stop.

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3. Support and Resistance Levels

Using established support and resistance levels to set stop-loss orders is a reliable strategy. If the price breaks through these levels, it signals that your trade idea has been invalidated.

When employing this method, avoid placing your stop-loss too close to the support level. The price may briefly dip below support before reversing. Instead, set your stop slightly below the support to account for these potential spikes.

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4. Time-Based Stop

Time-based stop-loss orders help traders exit stagnant positions and taking up capital. This method is particularly useful for short-term traders who prefer not to hold trades overnight.

Some traders set rules to close their positions by a specific time, such as Friday evenings to avoid weekend risk. Intraday traders often limit trades to the same day to prevent adverse movements while they're inactive.

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The Bottom Line

No one likes losing money. But inevitably, trading is a game of probability, which means every trader will invariably be wrong sometimes. When a trade goes wrong, you have only two choices: to accept the loss and liquidate your position, or to double down and potentially sink with the ship.

If you don’t want to be part of a sinking ship, you need an effective stop-loss placement that aligns with your trading strategy. This could be percentage stops, volatility stops, or support and resistance levels. Whichever you choose, always give it some breathing room to avoid potential stop hunts.

For traders looking for risk-free capital, try Optimal Traders. We offer comprehensive support, education, and access to a community of like-minded traders. However, even with our capital, you still need a solid stop-loss placement strategy to pass our prop challenge.