A stop-loss is a predetermined price at which a position is closed to limit the loss; position sizing decides how many shares to buy so that, if the stop is hit, the loss equals a fixed, acceptable amount. Together they cap the damage any single trade can do to an account.
How it works
Most traders size positions with the fixed-fractional method, which takes five steps:
- Choose the account risk per trade: a fixed share of equity, commonly 0.5% to 2%.
- Set the stop where the idea is wrong: below support, under a swing low, or a multiple of the stock's average true range (see ATR stop), not where the loss merely feels tolerable.
- Measure the per-share risk: entry price minus stop price for a long position.
- Calculate the size: shares = account risk ÷ per-share risk.
- Check the limits: cap the position's value as a share of equity (20%, for example), and make sure the stock trades enough to exit at the stop.
The order matters. The stop comes from the chart, and the size follows from the stop. A wider stop means fewer shares, not more money at risk.
How to read it: R multiples
The initial risk per share is called R. Every result can then be expressed in R: result = (exit − entry) ÷ (entry − stop). A trade that makes twice its initial risk is +2R; a trade stopped out as planned is −1R. Measuring in R makes trades of different sizes and prices comparable.
Over many trades, expectancy = win rate × average win in R − loss rate × average loss in R. A system that wins 40% of the time with an average win of +2.5R and an average loss of −1R has an expectancy of 0.4 × 2.5 − 0.6 × 1 = +0.4R per trade, before costs. A low win rate can be profitable; a high win rate with large losses may not be.
Fixed-fractional sizing also limits the effect of losing streaks. Ten consecutive losses at 1% risk each leave about 90% of the account (0.99 to the 10th power ≈ 0.904). At 5% each, about 60% remains, and recovering a 40% loss requires a 67% gain.
Worked example (illustrative numbers)
| Item | Value |
|---|---|
| Account equity | $50,000 |
| Risk per trade (1%) | $500 |
| Entry / stop | $40.00 / $38.00 |
| Per-share risk (1R) | $2.00 |
| Shares = $500 ÷ $2.00 | 250 |
| Position value | $10,000 (20% of equity) |
| Target at $44.00 | +2R, +$1,000 |
If the stock instead gaps down and opens at $36.50 after bad news, the stop fills near the open: the loss is $3.50 × 250 = $875, or −1.75R. A stop limits a loss under normal trading; it cannot guarantee the exit price.
Limitations and common mistakes
- Moving the stop further away once the trade goes against you, which turns a −1R loss into a much larger one.
- Sizing by conviction rather than by the stop distance.
- Ignoring gaps. A stop order becomes a market order when triggered and fills at the next available price; a stop-limit order may not fill at all (see stop vs stop-limit orders). Earnings dates are the most common source of gaps.
- Stacking correlated positions. Five semiconductor stocks at 1% risk each behave like a single 5% bet when the sector falls together.
- Stops inside normal noise. A stop tighter than the stock's usual daily range is likely to be hit by noise; volatility-based stops address this.
- One percentage stop for every stock. A flat 5% stop ignores how differently stocks move: it is too tight for a volatile stock and too loose for a quiet one.
- Forgetting costs. Commissions and slippage reduce every R, especially on short-term trades.
In Clear Tape
Every Clear Tape trade alert states its stop and target, and alerts show the result as an R multiple. The Today page shows how much of Clear Tape's portfolio would be lost if every stop were hit. In trading systems, each signal comes with an entry, a stop and a target, with R defined as entry minus stop, and a system's target can be set as a multiple of R. Backtests let you choose the risk per trade (0.1% to 5% of equity); they start from a $100,000 account, cap any position at 20% of equity, and report each trade's R, the average R and expectancy after costs. Trade alerts are available to Pro members; watchlist screening and backtests to Tools and Pro members.
For educational purposes only. Not investment advice.