Day Trading Stop Loss Strategy
What is a Stop Loss Strategy
One of the most critical strategies for a day trader is the day trading stop loss strategy. The concept of a stop loss strategy in day trading constitutes stopping the trade immediately when the market starts moving against the traders’ expectations. Such a stop loss strategy ensures that the day trader can limit his losses, while retaining the profits already earned by him.
For instance, a day trader holds a long position in security at $100 and will incur losses if the price of the security goes down. In this case, if the trader locks the stop loss at, say, $98, and the price starts plummeting down, the security will automatically be sold when it reaches $98 even if the price goes further down to $90. Stop loss will limit the losses that the day trader is to suffer.
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Why Does One Need A Stop Loss Strategy
Day trading is a highly volatile process. It involves dynamic movements and spontaneous decision-making. While being rewarding, day trading comes with high risks. A day trader must use strategies to eliminate risks and increase profits, as much as possible.
The stop loss strategies in day trading also induce discipline in the process of trading. The effect of human emotions like fear and greed gets reduced, and the performance of the trade becomes more dependent on the actual parameters rather than the ‘feelings’ of the traders. The price level decisions for exit are pre-made after a considerable amount of research. Therefore, the trader does not get involved in hasty decision-making right at the time of the price movement.
Stop loss limits the risks in a trade and protects the trader from sudden spikes or drops in the prices. It is equally significant to set proper stop loss as it is to implement adequate entry strategies. Overall, the correct placement of stop loss impacts the performance of a trade on many levels.
How to Pick the Correct Stop Loss Strategy for You
Picking the correct day trading stop loss strategy is as critical as deciding to use one. Even if a trader is using stop loss but does not use the suitable strategy, the output remains restricted.
Day trading stop loss strategies can be either of the following:
- Confluence Stop Loss Strategy: This strategy is the most common for day traders and uses moving averages, price highs and lows, support and resistance levels, trend lines, and other indicators to determine the stop loss placement. Stop loss is placed on a key position on the graph.
- Volatility Stop Loss Strategy: This stop-loss strategy is most suitable for dynamic markets. Traders use larger stop losses in stocks with high volatility, and conservative stop losses in stocks with smaller swings.
- Time-based Stop Loss Strategy: Time-based strategies are usually employed in combination with other strategies. When the trader enters a trade and nothing happens for an extended period, the time-based stop loss strategy helps him exit the trade rather than the trader remaining stuck in a position that drains his buying power.
Thus, the choice of the most suitable day trading stop loss strategy depends mainly on the risk appetite of the trader and what he expects out of the trade. It will also depend on the market conditions and the volatility of the market.
Stop Loss Strategy is Not Enough
To process a thriving trade, it is not enough to base it only on a stop loss strategy. Many other important aspects need to be considered.
Many traders choose their stop loss based on their profit potential or the risk-to-reward ratio, which does not turn out to be an effective method in most circumstances. It is imperative for the traders to identify a price level at which their trade idea will be proven wrong, and set up stop loss accordingly.
The use of trailing stop loss is a suitable addition to a stop loss strategy. Trailing stop loss involves putting stops at a trailing distance from the highs, in case of a long trade. If the price of the security keeps rising, the stop loss also keeps increasing by the trail amount.
Importance of Practice
Practice is what differentiates a successful day trader from an unsuccessful one. It is because day trading is a complex phenomenon and no trader can excel at it without giving it a lot of time, patience and discipline.
Day traders must create a demo account before entering into real trades. Strategies, including the entry, exit, and especially stop loss, must be formulated on papers first, based on a lot of research. This process takes the trader through a process of learning, implementing, correcting, reformulating and reimplementing.
Practicing guards the traders from hefty losses in the live marketplace. Traders will learn about the drawbacks of their own game, in a simulated environment, instead of absorbing it the hard way by losing real hard-earned money.
As a bottom line, day trading stop loss strategy is one of the most efficient exit strategies. It ensures that the day trader pre-formulates his exit, based on research and experience. By doing so, the trader will not have to take sudden, spontaneous and hasty decisions during the trade and the entire process will become more structured rather than based on emotions and circumstances.