Stops Matter! They Will Save Your Account (or Your Profits)

Risk management is an important concept in day trading and investing because of the substantial risks involved. It is so vital since any trade that you execute has a 50-50 chance of being profitable.

One important concept in risk management is known as using a stop-loss, one of the most useful orders in trading. In this article, we will look at everything you need to know about a stop-loss.

What is a stop-loss?

A stop-loss is a tool that automatically stops a bearish or bullish trade when it reaches a certain loss threshold. For example, assume that a stock is trading at $10 and you decide to buy it. In this case, your trade will be profitable as long as the stock is above $10.

In this case, you can decide to protect the trade by placing a stop-loss at $8. As a result, if the stock drops to $8, the broker will automatically stop it. In this case, you will be safe if the stock continues dropping below $8.

Stop-loss vs a trailing stop

Another important concept is known as a trailing stop. This is a tool that solves a key challenge that a stop-loss has.

This challenge happens where a profitable trade suddenly turns unprofitable. For example, you can execute a buy trade at $10 and set a take-profit at $14 and stop-loss at $6. In this case, the trade can work and the stock can rise to $13 and then dip suddenly to $6. In this case, the original profits you generated will not count and your trade will have made a loss.

A trailing stop solves this challenge by ensuring that the original profits are not lost when the stock falls hard.

Rules for using a stop-loss

There are several rules to remember when using a stop-loss. First, always ensure that you have set the stop-loss at the right place. Doing that will help you not make the mistake of setting a stop-loss where it is not needed.

Second, always stick with the stop-loss and don’t adjust it during a trade. This is where people go wrong. They set a stop-loss and then adjust it if the trade is making a loss. They hope that the trade will have a turnaround and move towards profitability.

Third, in most cases, for the benefits we have mentioned above, use a trailing stop-loss instead of a normal stop instead.

What is a take-profit?

The concept of a stop-loss is similar to that of a take-profit. A take-profit is a tool that automatically stops a trade when it reaches a certain profit threshold.

For example, in the example above, you can place a take-profit at $12. In this case, the broker will automatically stop the trade when it rises to $12. Most successful traders always use a stop-loss and a take-profit in all their trades just to be safe.

At times, these stops will often work against them. For example, if a stock drops to the stop-loss and then resumes the bullish trend, you will miss that opportunity.

A good example is what happened during the 2010 flash crash. At the time, stocks crashed hard and then resumed a strong bullish trend. As a result, trades that were stopped using a stop-loss lost the opportunity of the bullish trend that emerged.

At the same time, if a stock moves to the take-profit and then continues rallying, it means that a trader will have lost an opportunity.

How to set a stop-loss

There are several approaches to determining where to set a stop-loss. One of the most popular approaches is to determine your risk-reward ratio and then use it to set the stop-loss.

For example, most people have a rule that they should not lose over 5% of their accounts in a single trade (the most conservative choose 2%). Therefore, if you are opening a single trade, you should always ensure that the maximum drawdown you can have is 5%.

For example, assume that a stock is trading at $10 and you have $100,000 in your account. In this case, 5% of these funds is $5,000. Therefore, when you open a trade, you should set a stop-loss at a location where the maximum loss is this amount.

This is the simplest method of calculating a risk-reward ratio. Some traders use a more complex process that incorporates their historical performance and the ratio between winning and losing trades.

Another rule when setting up a stop-loss is that it should not be extremely close to the opening price. The reason for this is that an asset tends to waver after execution. As a result, when you set up extremely close, it will likely be executed and make you to lose money.

Stop-loss for traders vs investors

A common question is whether a stop-loss should apply to both traders and investors. For starters, there is a wide difference between the two. A trader is someone who opens trades and holds them for a few hours. On the other hand, an investor buys an asset and then holds it for a few days, months, or years.

Related » Value Investor VS Trader, here's why the latter is better

The two types of participants should always have risk management strategies. However, at times, an investor should be careful about using a stop-loss.

For example, if they initiated a buy trade at $10 and they hope that it will rise to $15, setting a stop-loss at $8 can be a bit risky since the shares has a high possibility of falling before continuing the bullish trend.

For traders, on the other hand, a stop-loss is a must for all trades to protect the potential downside.

Summary

In this article, we have looked at one of the most important topics in risk management. We have explained what a stop-loss is and some of the top rules to use when using the tool.

External useful resources

  • Stop Hunting In Trading Exists, But It’s Not What You Expect It To Be - Tradeciety

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