Protecting trading capital is essential, and stop-loss orders are a core risk-management tool. A stop loss automatically exits a trade at a set price, limiting losses if the market moves against you. Traders use different stop-loss methods depending on their strategy and market conditions. Below we explain common stop-loss types in plain language, say when they work best, and give simple examples for each.
Fixed-Percentage Stop Loss
- What it is: You set the stop at a fixed percentage away from your entry price. For example, you might decide to always risk 5% on a trade. After you buy, you place a stop 5% below your entry.
- Works best for: All-round simplicity. It’s often used in swing or position trading where volatility is relatively stable. It’s easy to calculate and stick to, but doesn’t adapt to big swings in price.
- Example: If you buy a stock at Rs.100, a 5% stop-loss would be at Rs.95. If the price falls to Rs.95, the order triggers and you exit. This keeps your loss to about 5% of the entry price.
Check out position size calculator here
ATR-Based Stop Loss (Volatility Stop)
- What it is: ATR (Average True Range) measures how much an asset typically moves. An ATR-based stop sets distance as a multiple of this volatility measure. In simple terms, you give the trade a buffer based on recent price swings. The higher the ATR, the wider the stop.
- Works best for: Trending or volatile markets. Swing traders and day traders like ATR stops because they adjust to the market’s noise. In calm markets the stop tightens; in wild markets it widens, reducing “whipsaw” exits.
- Example: Suppose a stock’s ATR is Rs.2 and you buy at Rs..00. A common rule is a 1.5× ATR stop. So you’d place the stop at Rs.100 – (1.5×Rs.2) = Rs.97. If volatility rises (ATR grows), future stops would automatically be set farther away.
Structure-Based Stop Loss
- What it is: This method uses chart structure like support/resistance or recent swing highs/lows. You place the stop just beyond a key level on the chart. The idea is that if price breaks that level, the trend has likely changed.
- Works best for: Trend-following or swing trades. Also useful in range-bound markets if you buy at a support bounce or sell at resistance. It assumes technical levels act as natural safety barriers.
- Example: Imagine you buy a stock that bounced off a support level at Rs.50. The last swing low was Rs.49. You might place your stop just below Rs.49, say at Rs.48.75. If the price dips below that swing low, the stop hits and you exit, indicating the support failed.
Time-Based Stop Loss
- What it is: You simply exit a trade after a set time if your target isn’t hit. This time-stop forces you out by a deadline (e.g. end of day or after N days). It’s like saying “if this trade doesn’t move by X time, I’ll take the loss”.
- Works best for: Time-sensitive strategies. Day traders often use end-of-day stops to avoid overnight risk. Swing traders might exit if a trade stalls after several days. It’s also used to test entries (e.g. exit if no breakout after 5 bars).
- Example: A day trader goes long an intraday breakout. They decide any profit or loss must materialize by market close, so they set a rule: close by 3:55 PM if the stop hasn’t hit. This prevents holding overnight risk.
Indicator-Based Stop Loss
- What it is: You use a technical indicator as your stop signal. For instance, close the trade if price crosses a moving average or breaches a volatility band. These stops are systematic and often trending in nature.
- Works best for: Trend-following strategies or markets with clear momentum. For example, a trailing moving average stop lets winners run while protecting gains.
- Example: A common rule is the Moving Average Stop: exit when price crosses below a chosen moving average. Suppose you’re long and using a 20-day MA. If the price closes under that MA, you exit. This way, your stop follows the trend. Another example is a Bollinger Band stop: you might exit if price closes outside the lower band, indicating a big momentum shift.
Beyond the basics, traders have developed advanced methods and hybrids:
- Breakeven Stop: Once a trade is comfortably profitable (say up 1× the initial risk), you move the stop to your entry price. This locks in a no-loss trade. Example: You risked Rs.100 to make Rs.100. When you’re Rs.100 up, you set the stop to entry. Now you can’t lose money on the trade.
- Volatility-Scaled Stops: Some use volatility percentile or ATR adjustments. For instance, if volatility spikes, you might widen your stop or even reduce position size. (Luxury trading blogs suggest cutting position size or shifting targets when ATR is extremely high.)
- Market-Driven Stops: Using market metrics instead of price alone. A VWAP stop exits if price dips below the Volume-Weighted Average Price, signaling loss of support. Liquidity stops (a research concept) react to order-book depth changes. These are mainly used by algorithmic or institutional traders.
- AI and Algorithmic Stops: Emerging tools use machine learning to adjust stops in real time. For example, a system might feed live volatility and price data into an AI model that recommends a dynamic stop position. This is cutting-edge and mainly seen in quant trading.
- Other Concepts: Some traders test gapping stops (exiting if a gap against them occurs), or combine stops with profit targets (e.g. scale out gradually). Overall, modern approaches often blend methods: for instance, using an ATR distance but moving it with price like a trailing stop.
Each method has trade-offs. The best stop for you depends on your style and the market. For instance, fast scalpers might favor tight fixed or time stops, while swing traders often use structure or ATR stops. Always backtest and paper-trade your stop rules. Clear, rule-based stops help manage risk and keep emotions in check.
Disclaimer:
The information provided in this article is for educational purposes
only and should not be construed as financial advice. The content is
based on publicly available information and personal opinions. Readers
are encouraged to conduct their own research and consult with a
qualified financial advisor before making any investment decisions. The
author and publisher are not responsible for any financial losses or
damages incurred as a result of following the information provided in
this article.
