In day trading, a stop loss is a must. Before entering a trade, the trader must know precisely when he is getting out if the trade goes against him. For example, if a currency trading strategy calls for a stop loss to be placed below the low of the previous 30-minute bar on a long position, it must be done. A trader has to be very disciplined about this (please note that even though placing a stop loss order doesn’t guarantee that you’ll get filled at a certain price, I think it is still important).
When exiting a trade with a loss depends on an indicator reaching a certain value or condition, the stop loss order cannot be placed right after the trade is entered. For example, in the basic explanation of the moving average crossover strategy, a long trade is entered when the short-term moving average crosses over the long-term moving average and it is exited and reversed (short trade established) when the short-term moving average crosses below the long-term one. Consequently, in a strategy like this a trader has to wait for a crossover before exiting a position.
There are some other strategies where the exit point from a losing trade is a fixed amount or is based on a preexisting level on the chart. For example, if I was using a day trading strategy where the exit point for a long trade due to a loss was one cent below the low of the previous 15-minute candle, then I could place a stop loss order right after I would enter the trade. Let’s say that I bought 500 shares of XYZ at $25.20 and that the low of the previous 15-minute candle was 25.05. Right after buying the 500 shares I would instantly place a sell stop order at 25.04 (one cent below the low of the previous 15-minute candle). Thus, my stop would be in place at 25.04 and if the stock came down, I will exit at a price near 25.04.
The reason why I like this type of strategy is because by forcing himself to place a stop loss order every time after entering a trade, a trader will be building discipline and learning to treat losses just like gains (becoming emotionally detached from his trades). By physically placing the stop, a trader won’t run the risk of holding a losing position too long due to the use of discretion or because of fear.
An effective strategy must be very clear on where stops will be placed to limit a loss and all traders should learn how to use proper stop loss placement techniques.
Since trading capital is the lifeblood of a day trader, he must protect every ounce it. The best way to do this is by knowing before entering where his exit point will be. Not only should the trading strategy provide the trader an entry with a higher probability of making money, but also with strategic and specific points to limit losses. These stops should keep the losses from bad trades at a manageable level and also be flexible enough to give winning trades room to grow.
In my day trading risk management section I suggest how much you should risk on each trade and how big your trading positions should be.