How To Set Up The Right Stop Loss?

The stop loss is designed to set a predefined percentage value for exiting a trade when the position's value falls beneath the threshold.

Finding a one-size-fits-all value for stop-loss isn't practical as it must account for several factors. For example, the trader's risk tolerance plays a significant role. Although a larger stop loss might enhance win rates and potential returns on trading assets, not all traders are equipped to take such substantial risks every time they trade.

Market volatility is another vital consideration. If the stop loss is too small, market noise might trigger it instead of an actual drawdown. Therefore, setting the stop loss slightly above the maximum adverse excursion (MAE) is generally suggested.

However, the average trader might find it challenging to perform these complex computations, making the backtesting tool a valuable resource. By adjusting the stop loss value via this tool, traders can identify the stop-loss position that yielded the best historical return.

The same problem on overfitting, a problem highlighted mentioned in the previous blog is also a concern here. Therefore, precise backtesting isn't always necessary to pinpoint the perfect value. Running the strategy live with a paper trading account, or setting a value based on personal experience for subsequent refinement, can be more practical approaches.

Common stop-loss percentages for stock traders usually fall within the 5-10% range for each stock, assuming they aren't betting their entire portfolio on a single stock. For other assets, it's typically suggested not to risk more than 1-2% of the portfolio.

With this foundational knowledge, you can perform initial calculations to establish a test run value and then adjust this value based on the insights gathered from future trades.

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