A stop-loss order is probably the most effective way to cut your losses (as the saying goes), and not let them run to the point of damaging your trading kitty. A stop-loss order needs to be set as you enter the position. But where to place a stop-loss can be difficult, because there are an infinite number of possible places.  In this article I’m going to share my strategy, using the example of the S&P 500 chart over the last year.

I think of the market as a war zone between two forces or armies: the buyers (bullish) and the sellers (bearish). The market moves in the direction of the stronger army.

The support and resistance zones are like the base camps for each army. The support zones are the bullish army’s base and the resistance zones are the base for the bearish army. Both armies aim to conquer the opposition and take over their base camp. So when a resistance zone is broken it turns into a support zone and vice-versa.

Highs, lows and moving averages

When taking on a position, you’re placing a bet on which army is going to win the next battle. Placing a stop-loss order is about identifying where the group you’re betting on might lose its will to fight. Highs, lows and moving averages are very helpful in identifying these places.

For example, we know that when the market is bullish, it makes higher highs and higher lows. So if the markets start to make a lower low, it signals that there may be a shift in the balance of forces.

Most technical pattern rules have some guidelines about where to place a stop-loss. At its core, this is based on the principle of identifying signs that the force you’re betting on isn’t winning the battle.

To illustrate let’s look at an example using a trading simulator trading the S&P500 index over the past year. (Daily chart)

Here I’m buying, because I can see the bullish force come back in the market after successfully defending its territory. If I’m right, the market shouldn’t take the low of the Doji (the reversal candle at the support zone).

Because I’m a position trader (I trade by building a position in a trending market), I don’t have to take profit targets. So I don’t stress much about risk-reward ratios when I enter a trade. I typically only exit on stop-loss. In this chart, I would then watch to see what happens when the market reaches the top of the range. Will the bearish force defend their territory?

As it happens the bearish force came before that and established a resistance lower than where I initially thought they would. But it wasn’t enough to even threaten my stop-loss. And the bullish force defended their territory, which also happens to be at the 50-day exponential moving average (EMA). Now I’m interested in how the bearish force will react when the market reaches the new low resistance zone.

It turned out they emerged much stronger. The level which I identified (where the market shouldn’t go if I’m right on the trade) was taken out. The market made a lower low and I was taken out.

Cut your losses

The market fell much further, illustrating the importance of cutting losses and not letting them run further. It also highlights why having the stop-loss order placed in the market and not just in your head is important. If the market trades to the stop-loss, I exit. No questions asked. Placing the stop-loss order  in the market when I enter the trade, commits me to that action.

The dance begins

However, the bullish force did come back again. Not trying the last trade again, I see this as a completely new trade independent of the previous one. This time I’m using the 50-day EMA as a guideline for my stop-loss. If I’m right on the trade, the bullish force should successfully defend the 50-day EMA. Then I wait to see what will happen if the market reaches the current resistance and the highs as well.

Adjusting your stop-loss

As it so happens, the market goes on to a new high close. If I wasn’t in the trade already, this would be a buying signal. I again look for a zone that the bullish army should be able to successfully defend, should the sellers rally. But because I am in the trade already, I only adjust the stop-loss to the new level.  What was a resistance zone, will now become a support zone. Now my stop-loss is better than breaking even. I would add to the position if the new level has protected enough profits.

I would have stopped when the market made a lower low but the market was still strong, coming back to make a new high. So I took the trade again with the same principles of using the low of the last swing, as the level beyond which the bullish force is no longer convincing. However again the market established a new low, and I was stopped out.

As before, if a new opportunity comes again, I would take the trade. And as before, I would look for areas where the opposing army will rally, and which areas my army should be able to successfully defend.  And then wait.

It’s not perfect science

I do this dance throughout the lifecycle of the trend. It’s not perfect science, and not without errors and mistakes. Sometimes the stop-loss is too tight, sometimes I’m too quick to adjust the stop and/or add to the position. It’s a continuous learning process. But I’ve gotten better and better as the years have gone by.

The whole idea of a stop-loss is simply picking a point where it’s no longer worth losing another cent to stay with your bet.

A stop-loss is an important component of risk management. And risk management is a crucial part of the trading process. We need to learn the art of not only placing stop-losses, but also managing them.

Traders share a peculiar characteristic: they’re fiercely competitive, but only with themselves. In practice this means that they see every outcome as an opportunity to learn, and they’re brutally honest about both their failures and successes. This also means that they’re hungry for knowledge. They don’t sleep easy with unanswered questions. And they’re seldom satisfied with just one answer.

Njabulo Nsibande is a founder of Village Trader, and Sakha Ingcebo investment club. His interest in trading began in 2016, alongside a rash of Instagram ‘fx traders’…

Find him on Twitter: @njabulo_goje.