There are several different methods you can use to determine the price level for setting an initial protective stop. Each method has its advantages and disadvantages and the application of any of these methods is not an exact science. The methods most often used are:
1. Dollar Based Stops
2. Pattern Based Stops
3. Volatility Based Stops
1. Dollar Based Stops
Dollar Based Stops are very straightforward as you simply decide how much you want to risk in dollars per share in a particular trade or market, and place your stop accordingly. For example, you believe Dell will make a move to the upside and you have decided to buy Dell at $48 with a limit order. You would then decide the dollar amount per share to risk if the trade goes against you by setting an initial protective sell stop at $47 ($1 stop), $46 ($2 stop), $45 ($3 stop), etc. The advantage is that you only risk a dollar per share level you are comfortable with. The disadvantage is that the market is totally oblivious to what your level of assumed risk is and the stock will trade wherever market dynamics take it.
Using dollar based stops that are too tight will decrease trading performance and increase losses as trades that would have eventually become winners get taken out (stopped out) too early. However, it is crucial for short-term traders and day traders to keep losses to a bare minimum on the numerous individual trades they make. Day traders who put on trades with profits limited to how much a stock can move in one day usually risk a fixed dollar amount using dollar-based stops. Long-term traders looking for larger profits over a longer-term trend would be better served by trying to determine the volatility of the stock. Then, a volatility-based stop could be applied to avoid being stopped out by "normal" fluctuations in the stock's price.
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