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What is Stop Loss in Stock Trading and a Simple Strategy for Optimum Results using PSAR, ATR, and other indicators

Updated on June 27, 2018

What is Stop Loss?

Stop Loss is basically an automatic sell order: if the stock price falls below this amount, sell that stock! It is simple, but picking the amount can be quite complex.

Stop Loss reduces your management effort considerably, as you don't have to constant worry about the prices and call up your broker (or fire up your online trading tools). However, setting a good stop loss target can be very tricky. if you set it too close to the current price a random fluctuation will cause the stocks to be sold. If you set it too far you'll lose a lot.

A 5% trailing stop loss is often used. What that means is the stop loss is set at 5% below the closing price. However, this may not be an ideal number when the stock is a very volatile one, with large price fluctuations that often exceed 5%.

Let us discuss a strategy as illustration, and then I will show you an even simpler strategy that is easy to calculate.

NOTE: Stock charts produced by AptiStock

PSAR - Parabolic Stop and Reserval

PSAR is a simple way to set stop loss based on the trends. In the sample chart, you can see the prices of AAPL (Apple) from August to November 2009.

The purple dots are the SAR sell points. Notice that they can be above OR below the price curve. When it's below, that's a stop-loss point. When it's above, it's time to go short (i.e. short sell the stop and set the stop-loss at the high point). However, when it comes to an upward trending market it's better to ignore the short-sell signal, and only use the "below" stop-loss signals.

As you can see from the chart itself, you would have sold the stuff several times in the fluctuation between W32 and W36, and again at W39 and W41, had you relied on this signal exclusively. Thus, this signal is NOT that good when the market is "trading" (i.e. going sideways). It is fine in trending markets (going up or down).

AAPL, August - November 2009
AAPL, August - November 2009

ATR -- Average True Range

Another way to calculate the stop-loss is by utilizing the ATR indicator. Buy in when it reaches a new all-time high, then set the stop-loss at 10 ATR (10 Average True Range). Keep updating it only as it reaches new highs. This would have saved you from losing too much. Using the ATR in this case takes into account of volatility of the stock. Volatile stock have large ATR swings, whereas stable stocks have low ATR swings.

ATR, or average true range, is basically the max high of the past X sessions, minus the the min low of the past X sessions. In our need, that would be 10, which is in other words, we want the ATR of the past 10 trading days. Just take a peek should tell you that's not that hard to calculate, and most charters should have the ATR.

Use the ATR as a negative offset to calculate the stop-loss. For example, if the stock price is 100, and ATR is 5, then your stop-loss should be set to 95.

Here is the same chart, with ATR(10) and the calculated stop-loss points calculated. As you can see, this method is actually pretty accurate. ATR remained low until October when it started to rise, so the "offset" is larger. If you had bought during the beginning of August, about about 168, and you had diligently updated your ATR(10) stop-loss you would have cashed out at either 181 or at 200.

AAPL August to November 2009, with ATR(10) and stop-loss points marked
AAPL August to November 2009, with ATR(10) and stop-loss points marked

Stop-Loss Effects on Long-Term Investment

If you plan for stocks long-term, you need to revise your stop-loss targets somewhat.

AAPL is trading at 330 as of January 2011, so if you had indeed sold much of it back in 2009 at 200 you'd have missed the 50% profit.

Consider multiplying your "offset" by a certain modifier, such as 150% if you are considering longer-term investments. If the ATR(10) says 5, you may want to use 7.5 instead. This will have the effect of canceling out the random noises, but also means if the stock tanks you will lose a bit more.

Conclusion

Stop-loss is a tool that is often under-utilized or misused by common investors because while it is easy to understand, it is very difficult to pick a good number. The two techniques above can be combined to form an effective stop-loss calculator without too much math or effort. Good luck.

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