One of the most frequently asked questions from active traders is where do I set my CFD Trailing stop loss? This can make the difference between exiting a trade too soon or holding until the end of the trend. It can dramatically affect the profitability of your trading. To determine when to get out of a trade studying past performance can be a useful guide to determining the next exit point.

The CFD trailing stop loss is an excellent exit strategy however determining the level of the stop loss is critical to your trading success. A share typically has a set volatility and the stop needs to be placed far enough away to avoid the market “noise”, yet close enough to exit in the event of a change in trend. Every share will require a different percentage value as the noise varies from share to share.

A tight CFD trailing stop loss will result in a trader holding a share for a shorter timeframe than using a wide trailing stop loss. There are two charts of Sydney Futures Exchange (SFE) below. In the first one SFE has a 3% stop loss and in the second one a 7% stop loss is used. The blue lines mark the exit points from the share. The share is sold when it hits the stop loss and is reentered when it reaches a new high.

With a 3 percent trailing stop loss the share is held for a few days to a few weeks.

Using a wider stop loss 7% SFE is held for a few weeks to a few months. The effect of a wider stop loss is to keep you in a share for longer periods of time allowing profits to accumulate when the stock is trending.

One way to determine the appropriate stop loss for a share is to apply the stop loss to the share before you buy it. Determine what percentage has worked in the past and then apply that percentage going forward. This can be done by trial and error, using your charting software and applying the stop loss to the share with different percentage levels.

Once you have found the level that is appropriate for the share historically and holds you in the share for the timeframe you are trading, use this percentage value going forward.

As a guideline short term traders holding shares from a few days to weeks will use a stop loss in the range 3 - 8%. Medium term traders that hold a share for weeks to months will use a stop loss in the range 6 - 10% and investors that wish to hold shares for months - years can either use a weekly or monthly stop loss with the above percentages or a stop loss recalculated daily in the range of 10 - 15%.

Another method that is rapidly gaining in popularity is the use of the Average True Range (ATR) to determine the stop loss level. The true range on any day is the difference between the high and the low of the day plus any opening gap that may occur. The True range is shown for three different candles.

The average true range is calculated by averaging out the true range over a number of days. 10 or 20 days are popular among traders. The average true range indicates the normal share price movement over a day. This can be considered to be noise, however a move of 2 - 3 times the average true range indicates something unusual is occurring.

Most charting software has the ATR indicator built into it. Trailing stop loss order systems allow you to specify a percentage movement, but the ATR is a price range. To convert the ATR into a percentage divide by the closing price and multiply by 100.

The ATR for SFE fluctuates between 9 and 15 cents. A move within this range is considered a normal movement for the share on any particular day. To calculate a percentage divide the ATR approximately 12 cents by the closing price $6.50 then multiply by 100.

The percentage daily movement for SFE is approximately 1.8%. A move of 2 -3 times this range would be used as a stop loss to give a stop loss percentage in the range 3.6 - 5.4% or
rounded 4 - 6%.

Sometimes this calculation will result in a very wide stop loss. If this is the case then there are two alternatives. If the ATR percentage was 6% then your stop loss setting will be 12 - 18%.

This is very wide and could result in large losses. Either do not take the trade or use a tighter initial stop, until you have got some profit behind the share and then allow the trailing stop loss to take over.

The calculation of the stop loss is important to ensure that you are not sold out too early and you hold the share to reach your profit levels. The level of the stop loss that you choose is determined by the timeframe that you wish to hold the share. The longer the timeframe, the wider the stop loss.

Determining what has worked well in the past will give an indication of the appropriate level for the stop loss or the level can be calculated using the ATR of the share. A movement of 2 -3 times the ATR is an abnormal movement for the share and this can be used as an appropriate exit point.

Jeff Cartridge
LearnCFDs.com

10 January 2009

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