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A Beginner’s Guide to Stop Losses

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Stop loss strategy can save you from going under water
A balanced stop-loss strategy can save you from going under water

Stop losses are important to stop losing money, but can limit your profits too – experienced traders realize a balance has to be struck

When trading, your priority is to manage and preserve your capital as well as possible. Sooner or later, we will all take a position on the wrong side of a market trend. That’s why stop losses are so important. In this article, we will explain some of the basics. These will include what a stop loss is, how to set them, and why they should be considered part of your trading strategy. However, in the interests of balance, we will also touch on some situations and circumstances where you may not want to use stop losses at all, but these options are reserved for experienced traders only.

What is a stop loss?

Put simply, this is an instruction you set up on your trading platform to buy or sell a stock, bond, commodity, financial derivative, or cryptocurrency once it hits a specific price. The buying or selling part depends on whether you are choosing to go short or long on your asset. Stop losses are aimed at helping you limit losses when you trade, and so often represent an important part of traders’ strategies.

It’s important to go into every trade with an analysis of what you are trying to achieve in your trading plan, but if things do not work out then you need to have a point to be reached where you say you are definitely wrong. That is what a stop loss represents.

What kinds of stop-loss orders are there?

There are two main types. The first is a sell/buy-stop order and the second is a stop-limit order.

Sell and buy stop orders

A sell stop order is useful to help prevent losses when the market moves down past the price you entered, and you want to limit your losses. When you go long on your trade, this is done by entering a stop loss that is a specified number of pips below the entry price. A buy stop order, on the other hand and as the name suggests, is used to protect short positions. It follows the same methodology but takes effect if the price rises above your buy-stop order. Traders who are shorting use buy-stop orders to be triggered if the price rises above the market price and past that buy-stop level.

Forex example for a sell stop order

To understand a sell-stop order better, we’ll use forex trading as an example. So if you enter an order to buy EUR/USD at 1.2000, but want to limit potential losses at 1.1180, then you could set your stop-loss order at 1.1180. This limits your risk of loss on your trade to 20 pips. This figure of 1.1180 is also sometimes known as the trigger price. Some trading platforms allow you to also set this up as a percentage loss, not just the exact price figure.

These orders get filled at the next available price on the market. So if you set your stop-loss market order at 1.1180, as per the example above, when the market hits that price, it will be filled at whatever price is available. Therefore, that doesn’t mean your losses are necessarily limited to 1.1180. It is important to note that they could be far lower if there is strong volatility in the market. That’s why you may want to set your stop-loss price slightly above the selling price you want, so perhaps enter 1.1182.

Stop limit order

A stop-limit order is different and represents another way to overcome this problem. The clue is in the word “limit”, which tells you that this type of order imposes a threshold on what price the order will execute. There are two prices are involved.

The first is the limit price, as just described, where the order will only execute at the price set as the limit. The filling of this kind of order is not guaranteed because the price may be volatile. Traders sometimes use these if they have the patience to wait for the price to rebound to the limit price they have set. The second price involved is the stop price, which executes the sell order.

Forex Example

A trader buys EUR/USD at 1.2000, but the price rises 100 pips to 1.2100, never falling to the stop-loss price set of 1.1180. The trader cancels his stop-loss order at 1.1180 and puts in a stop-limit order at 1.2080 with a limit of 1.2050. If the price falls below 1.2080, then the sell-limit order becomes live. If the price falls below the 1.2050 limit before the order is filled, then the order will stay unfilled unless the price returns to 1.2050.
Stop-loss and stop-limit orders can provide different types of protection for both long and short investors. Put simply, stop-loss orders ensure execution, whereas stop-limit orders guarantee the price.

Reasons to use stop losses

Apart from being a free insurance policy, the main advantage of a stop loss is that you don’t have to constantly check on how your trade is performing. If you work full time or decide to take a break from your phone and laptop, the stop loss will be there to make sure that the market does not run away with your money.

They also eliminate emotions from your trading strategy. Becoming emotionally invested in your trading decisions is something to watch out for, and stop losses help remove this sense of attachment. With human fallibility, the unfortunate reality is that we do not always make the right decisions.

Stop losses are particularly useful to avoid holding on to a position and burying your head in the sand if the market continues to move in the opposite direction to what you want. Sleepless nights are no fun, and the regrets you can have about not using a stop loss are serious. Then there is the added worry and stress of perhaps having to wait for the price to reach a break-even point.

It’s important to remember that stop loss orders don’t just help stop you losing money. They can also help you lock in profits you have made.

Disadvantages to stop losses

The main downside to stop losses is that it often takes only a short-term movement to trigger your stop price. The best way to counter this problem is to choose a stop-loss that strikes a healthy balance between allowing daily fluctuations and limiting your downside risk. Check the history of fluctuation involved and make sure that the stop loss you set is in line with the trends you are seeing.

Another key issue is that there are no strict rules as to where your stop-losses should be set. This approach is dependent on your experience level, not to mention your style of trading. For example, if you are a day trader, then you may choose a smaller pip distance from your entry price. However, if you are investing for the long term, you may want to extend that more.

It is also crucial to understand that once your stop price is reached, the selling price may be considerably different to the stop price you have set since it will become a market order. This issue becomes particularly exacerbated in volatile markets where quick price changes are common.

To learn more about the pros and cons of stop losses, check this informative video here:

Reasons not to use stop-losses (for experienced traders only)

It’s natural to want to reduce your risk, which is why stop loss orders are so popular. Regardless of how much you are trading with, that impulse is always there. However, using them may not always help you to achieve your trading goals, especially if you are an experienced trader. Here are just some of the issues:

Markets go stop hunting

There’s a general liquidity hunt in the markets, and experienced traders will often look for stop losses. This is known as stop hunting. They will attempt to discover where stops are and try to drive markets towards those levels to get liquidity. Algorithms also hunt for liquidity and so if traders suspect that there might be some liquidity above a specific level, they may do some buying to see what happens when that level is hit. Simply by looking at a chart, it is possible to see that there are very often wicks above and below levels, which would stop you out if you had your stop at traditional points. This characteristic of market dynamics means you might question your rationale for putting yourself at its mercy and forego stops entirely.

Perfection is impossible

You can never be perfect, which is a healthy way of looking at a market. It is unlikely that you will achieve a perfect entry point, and certainly not every time. Therefore, it could be argued that using a finite stop is too ambitious. An alternative approach would be to use your judgement to scale in, scale out, work around the position, buy some more, close the positions off, buy some more, and then close them off again. In effect, this is a constant rotation of in and out, adding to your position, pulling it back and then adding to the position again. Although the domain of expert traders with several years of experience, many have become particularly adept at making high quality decisions using this approach.

Controlling risk with size

Since risk can be controlled with your trading amounts, perhaps a stop is not needed in certain circumstances. For example, if you are trading in small enough quantities to be able to absorb a huge move against your position, you may have the confidence and experience to manage the position accordingly. This allows you to take a complete view, analyse the situation and take a measured decision if, for example, the market has moved against you consistently. If in the worst-case scenario your position will not damage you significantly, then perhaps you don’t need to use a stop. Again, this is a strategy used only by traders who have significant experience and this goes for forex as well as options trading.

Many pros do not use stops

As already explained, it is quite common for very experienced traders to not use stops at all. However, they always have a point where they reassess and review how their position is doing and whether it is performing in the way they expected. They rely on their own judgement as to whether to unwind their position or not. However, the downside here is that if you are trading with leverage and are particularly sensitive to market moves, you could end up losing significant amounts of money.

This is why most traders will incorporate stop losses into at least some of their strategies – to mitigate this often-substantial risk. However, if you have a reasonable position size and can tolerate the occasional extreme move against your position, then you may feel that periodic re-evaluation is a better approach than using stop-losses. You have more flexibility with your decision making, choosing to either stay in, cut your position, minimize it or add to it, and then take informed actions rather than just pulling the plug without taking other data into account.

Conclusion

Understanding where to set stop losses can leave even the most experienced traders scratching their heads. If you set them too close, you will find yourself running out of position very quickly. If you set them too far away, you may incur significant losses if the market trends against you.

Moreover, depending on your circumstances and trading style, you may decide that stop losses are not for you at all. Although suitable for more advanced traders, there is method to the seeming madness of using your using re-evaluation points instead of stop losses, allowing you to make better decisions without exiting a trade too hastily.

As always, the key is practice and to use amounts and trading strategies that suit your risk appetite. Strategies which include stop losses and those that don’t all have their own benefits and drawbacks. It’s up to you to decide the level of risk you feel comfortable taking, and to not over estimate your abilities. Striking a balance is key. Practice in a virtual environment on your preferred platform and let us know your thoughts in the comments below!

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