Last Updated on November 22, 2022 by Oddmund Groette
With so many factors affecting the profitability of a trading strategy, using the right stop or exit method is necessary if you want to stand a chance of making money in the market. But must it be a stop-loss order? Are there other options for risk management, and what is the best exit strategy for swing trading?
The truth in swing trading is that there is no specific best stop or exit. As a matter of fact, a stop normally hurts performance!
A stop loss is an order placed with a broker to exit a trade once the market reaches a certain price against your position. Your stop loss level is the price level where you accept to realize a loss in order to prevent further potential losses on that specific trade. You set this price in advance either physically by placing the stop order with your broker or mentally by marking the price level at which you manually close the trade at a loss. The use of a stop loss is a common part of risk management, but it may not always serve your interest.
In this post, we take a look at the various stop or exit practices for swing trading. At the end of the article, we provide you with a few options that we consider better than using a stop-loss.
First, let’s define what a stop-loss is:
What is a stop loss?
A stop loss is an order placed with a broker to exit a trade once the market reaches a certain price against your position. Your stop loss level is the price level where you accept to realize a loss in order to prevent further potential losses on that specific trade. You set this price in advance either physically by placing the stop order with your broker or mentally by marking the price level at which you manually close the trade at a loss.
The main premise behind a stop loss is that it should work as insurance against being “wiped out”.
For example, let’s say you are swing-trading stocks and you buy Apple, Inc. stock (AAPL) at $120 and wants to set a stop loss at 10% of the purchase price.
Then, immediately after buying, (or even as you are placing the buy order in some trading platforms) you place your stop loss order at $108. If the stock falls to or below $108, your shares will then be automatically sold at the prevailing market price to stop you from losing more money on the trade.
So, a stop-loss is designed to limit your loss on any given trade. It is a defensive mechanism used to protect against further losses – like insurance. But while it is a common part of risk management, which is important for any strategy to be profitable, it may not always serve your interest.
Here’s why: the price often swings in any direction it wants, and it is common for the price to stop you out and still move in the direction you anticipated. Moreover, stop-loss orders can only restrict further losses, but they cannot prevent losses. In a fast-moving market, there may be a gap between the current market price and the stop-loss level you had set. There are many issues to consider before you implement a stop loss, and we believe you are better served by thinking a little creatively with stops (more below).
Different methods of setting stop loss orders
There are different ways to set the stop loss order. You can set a fixed dollar amount or a percentage of the purchase price based on your reward/risk calculation. For instance, if you buy a stock at $100 per share, you can set your stop loss at $10 below the purchase price or 10% of the purchase price. A better way to set a stop loss might be using stop based on market volatility. Some of the indicators you can use for this include:
- ATR-indicator: The average true range is a common volatility indicator traders use to estimate their stop loss. It is common to set the stop loss at a multiple of the ATR for the timeframe you trade on. For a swing trader who trades on a daily timeframe, the stop loss can be set at 3x ATR or more (for example), depending on the strategy.
- Standard deviation: Standard deviation is another volatility indicator traders use to estimate their stop loss. Setting the stop loss at 2 standard deviations is a common practice, but three standard deviations may even be better.
- Donchian channel: Some traders, especially those who use trend-following strategies, also use the Donchian channel to estimate where their stop loss should be. The indicator is mostly used for trailing stops.
Trailing stop: what is it?
This is a special stop order that is designed to trail the price when a trade is in profit. It is used to lock in profits.
Technically, it is not a stop loss order, as it closes a trade in profit, rather than close in a loss to potentially limit further losses. As with a stop loss, a trailing stop can be set as a percentage of the price or based on an indicator, such as a moving average or the Donchian channel.
What is an exit in trading?
In trading, an exit refers to closing a trade, which could be in profit or loss. It’s when you sell.
So, you can exit a trade by either taking a profit or taking a loss. For each situation, there are many ways you can implement your exit. The common ways are to use a stop loss to close a losing trade or use a profit target to exit a winning trade. Of course, most of the time you want to exit by using a set of variables. A sell algorithm is a major part of any trading strategy.
A profit target (take-profit order) is usually a limit order set at a pre-determined price level to close your trade once the price reaches that level. Unlike the stop-loss order, which is a stop order that is executed as a market order once hit, the take-profit (being a limit order) order is executed at the set price or a price more favorable to you than the current market price.
For a long position, the take-profit order is a sell limit order set above the current market price, while for a short position, the take-profit order is a buy limit order set below the market price. As we stated earlier for a stop loss, a profit target can be fixed arbitrarily or set based on indicators like the ATR that show market volatility.
Apart from the preset stop loss or take-profit orders, some automated systems also use the formation of the opposing signal or a specific price action to exit a trade. For example, a price action trader who enters a long position when a hammer candlestick forms may want to exit when a shooting star candlestick forms. Or a system that enters a buy order with an RSI oversold signal may exit with an RSI overbought signal.
Some of the factors to consider when formulating an exit strategy are your trading style, position size, reward/risk ratio, and risk tolerance.
Stop loss rarely works
Note that the zero case, which means no stop at all, has the best MAR ratio numbers. In fact, the test with no stops is better for all the metrics: CAGR%, MAR ratio, Sharpe ratio, drawdown, and length of drawdown – every single metric.
Curtis Faith, The Way Of The Turtle, page 145
Several eminent traders have, over the years, tested different stop loss strategies and came to the conclusion that stop loss rarely works in your favor. It is rare to find a winning stop loss — a stop loss that does what it is believed to do, which is to prevent catastrophic losses. What usually happens is that the price hits your stop loss and after a while goes back in the direction you predicted. This can be very frustrating, as it seems to limit your strategy’s profitability, rather than limiting losses.
This sentiment has been echoed by top traders, such as Larry Connors, Curtis Faith, and DE Shaw. For example, after running hundreds of tests to find the optimal stop loss levels, Larry Connors came to the conclusion that optimal stop levels do not exist. Instead, he found that stop loss hurts performance. Curtis Faith of the Richard Dennis Turtle experiment and DE Shaw also came to a similar conclusion. Curtis found that the best performance is without a stop loss.
But why is the use of stop loss counterproductive? There are a few reasons for that. One of them is that the price usually swings about its mean, so the farther away it is from the mean, the more likely it would swing back in the other direction. A stop loss hurts a mean reversion strategy. However, a trend following strategy might benefit from a stop loss. It all depends on the strategy in question. As always, a backtest helps you find the right balance between profits and a stop loss.
Using a stop loss takes you out of the trade before that happens. Another reason for stop losses not working is that institutional traders actively hunt stop orders, and even though stop orders are not recorded in the order books, they know the likely places retail traders put their stops and hunt for
The best stop loss for swing trading
It depends on your strategy and the result of your backtesting. Most people have found that the best performance is recorded when there is no stop loss. In that case, they use alternative risk management options to limit the risks of catastrophic losses, which is what the stop loss is supposed to deal with. Some of the alternative risk management methods include diversification across multiple uncorrelated asset classes and strategies.
For example, you can trade gold, silver, currencies, crypto, and crude oil in addition to stocks. And for each asset, you can deploy different uncorrelated strategies — such as trend-following and mean-reversion strategies.
Even when you want to use a stop loss, use a volatility-based stop loss that focuses on the volatility within a given timeframe the trade usually lasts. So, if your swing trades normally last a week, use a stop that matches that volatility so that it would no longer be an impediment to your trade but a tool to protect against fat tails black swan events.
A better approach could be to use a time-based stop and exit your trade after a chosen period — usually, the time it takes for your signal to be out of play.
But at the end of the day, there is no specific answer to what is the best stop loss in swing trading.
When to exit a trade
It is everyone’s wish to exit a trade in profit. It is always difficult to know when to take profit because if you aim too high, the price may reverse before reaching your profit level. And if you aim too low, you may leave a lot of profit on the table. At what profit to say it’s enough would depend on the strategy and what the backtesting performance metrics show.
For mean reversion, you must sell on strength, not weakness. Exiting on strength may not matter much to a trend-following strategy, as the aim is to trail the profit and milk as much of it as you can.
- What does it mean when the stock market is oversold?
- What does it mean when the stock market is overbought?
However, whichever strategy you use, you exit when the signal you are playing seems to have faded out. So, if you buy with an RSI oversold level and the indicator later shows an overbought signal, it may be time to exit the trade, regardless of the profit level.
Another thing to consider is the minimum favorable price excursion for your strategy. This refers to how far in your anticipated direction the price usually moves before reversing. In whatever you do, ensure you backtest your strategy before using it. That way, you would know the best exit strategy for optimum performance.
Best indicator for stop loss
The best indicators for stop loss are usually volatility-based indicators, and the most commonly used volatility indicator is the average true range (ATR). Traders use the ATR to estimate their stop loss, and they usually set the stop loss at a multiple of the ATR for the timeframe they trade on. For a swing trader who trades on a daily timeframe, the stop loss can be set at 3x ATR or more. For example, if the ATR is 50 points, the stop loss would be set at 150 points.
Another good one is the standard deviation, which shows how far away the price is from its mean price. Theoretically, the price is only 5% likely to hit its 2 standard deviations and 0.3% likely to hit 3 standard deviations, but this is only possible for a limit-defined time series, not price action that can trend rapidly in any direction. While setting the stop loss at 2 standard deviations is a common practice, it may be better to set it at three standard deviations of a specified period.
A stop should have a logical price
A stop loss level should be a price level that shows that the signal is unlikely to play out any longer. However, due to the erratic nature of price movement over the short term, it is very difficult to have a stop loss that does that and still retains a favorable reward/risk ratio. Look for a stop loss that accommodates the maximum adverse excursion (how much the price usually moves against your position before moving in your favor) of your strategy. If you cannot find that, consider other risk management alternatives.
The importance of exits
In a previous article where we made a sell the rip strategy we showed the importance of setting a good exit condition. For example, we made a strategy that had the following equity curve:
In our opinion, this is not a tradable strategy. However, we changed the exit condition and variable, and the strategy improved (a lot):
You increase total returns with smaller drawdowns! Why drawdowns are important you experience the hard way when you lose money. These two charts show you why you should spend time on the exit just as much as you study when to buy.
Further reading on stop loss and, profit targets, and exits
We are no fans of using a stop loss. As a matter of fact, we hardly use stops in our own trading. The reason is simple: it very rarely works.
Instead, we use alternatives to stop loss, for example:
- Trade smaller size
- Trade different markets/assets
- Trade different time frames
- Trade both long and short
- Trade uncorrelated strategies
We have covered all these aspects in a separate article about best stop loss strategy.
The same goes for profit targets: profit targets are not useful. We rather use a variable or a parameter that is flexible and takes us out when it’s beneficial and not by using a static number. You might also benefit from reading our trading exit strategies.
List of trading strategies with variable exits
Since we started this blog in 2012 we have written many trading strategies that you can read for free, please see our list of trading strategies. We have compiled the Amibroker code and login in plain English for all these strategies (plain English is for backtesting in Python). For a list of the strategies we have made please click on the green banner:
These strategies must not be misunderstood for the premium strategies that we charge a fee for:
What Is the Best Stop Or Exit for Swing Trading?
After reading so far we hope that you better understand that there are no best stop or exit in swing trading! Every trading strategy is lives a life of its own, and we see no logic in using a static stop loss order when you have so many better alternatives to a stop loss.