New traders obsess over entry points. "What's the perfect price to buy?" Experienced traders obsess over risk. "How much am I willing to lose?"
There are two main tools for managing risk: stop losses and position sizing. Most people use one but not the other. You need both.
Stop Losses: Your Emergency Exit
A stop loss is a pre-set price at which you automatically sell. If you buy a stock at $50 and set a stop loss at $45, the stock is automatically sold if it hits $45. Your maximum loss on that trade is $5 per share.
Where to set it:
- Below a support level (for technical traders)
- At a fixed percentage (5-10% below entry, common for position traders)
- At a point where the original investment thesis breaks (if you bought for earnings growth and they miss, the thesis is dead)
The problem with stop losses: In volatile markets, a stock can trigger your stop loss at $45, drop to $44, then bounce to $55. You got stopped out of a winning trade. This happens constantly. Stop losses protect you from catastrophe but they also guarantee you'll get whipsawed occasionally.
Position Sizing: Prevent the Problem
Position sizing asks a different question: "How many shares should I buy so that even if the stock goes to zero, I'm okay?"
If you have a $50,000 portfolio and risk 2% per trade ($1,000), your maximum position size is determined by how far you expect the stock to fall before you exit. Our Position Size Calculator does this math in seconds.
Position sizing is the more important tool because it prevents you from being in a position where a single trade can hurt you. Even without a stop loss, if your position is small enough, a 50% drop is a scratch, not a wound.
How I Combine Both
- Decide my risk per trade — Usually 1% of portfolio for individual stocks, 2% for ETFs
- Use position sizing to calculate how many shares to buy based on entry price and stop loss
- Set a mental stop loss — I write it down but don't always place a hard stop (to avoid whipsaw)
- Review weekly — If the thesis has broken, I sell regardless of price
Common Mistakes
- Setting stop losses too tight — A 2% stop loss on a volatile stock guarantees you'll be stopped out. Give your trades room to breathe.
- Moving stop losses down — If the stock drops and you move your stop loss lower, you're not managing risk — you're hoping. Set it and leave it.
- Ignoring position size — The most dangerous thing you can do is buy a large position thinking "I'll set a tight stop loss." Position size first, stop loss second.
Calculate your ideal position size with our Position Size Calculator before your next trade.