The Importance of Stop Loss Orders and How to Use Them – Introduction
In January 2015, the Swiss National Bank made a major announcement. It removed the peg that had been there since 2012 on its currency. This move was unexpected by the markets, which pushed the Swiss Franc higher. Other currencies had big swings during the day.
Again, in June 2016, the voters of the United Kingdom did the unexpected. They voted to leave the European Union. This was against what everyone expected. When markets opened on 27th June, the pound had its biggest decline in years.
Early this year, Bloomberg reported that the Chinese government was considering halting the purchases of US treasuries. Again, this unexpected news was a major one for the markets, which declined by the biggest margin this year.
Just last week, Facebook released its earnings for the second quarter. These results came two days after the impressive results by Google. So, traders expected Facebook’s results to be as impressive as those of Google. When Facebook reported, its EPS and revenues were better than expected but the guidance was soft. This led to a major decline in the stock price which wiped more than $130 billion of value.
These examples show the risks that traders go through every day. They also raise the important aspect of the need for being protected whenever a trader opens a trade.
One way for being protected is using the stop loss. A stop loss is a tool found in most trading platforms that automatically shuts down a losing trade when it reaches a predetermined level. This tool helps the trader protect the account and be comfortable with the loss that they make. In many cases, traders have seen their profits wiped out by one unprofitable trader.
A good way to place a stop loss is to consider your risk-reward ratio. This is a ratio that calculates the maximum amount of money you are willing to lose for every profitable trade. In the 1:2 ratio, for every two dollars of profit you make, you are ready to lose one dollar. While this is a common way to allocate the stop loss, another way is to factor in the winning ratio. For example, if you open ten trades, win six, and lose four, your success rate is more than 60%. You can factor this information when deciding on the ratio.
Another common way of using a stop loss is using a tool called trailing stop. A trailing stop is not fixed at a fixed level. Instead, it is based on a percentage below the market price. This tool helps a trader capture profits when a trade is open. It does this by moving up when a trade is open. For example, if you buy a stock that is trading at $20, you can put your stop loss at $16. If the price of the asset moves to $23, you will make $3 for every stock you hold. In certain times, a major news can come and wipe away all your profits. With a trailing stop loss, the level of the stop loss will move up with every upward move in the stock price.
Another way for using stops is by opening trades when a certain level is reached. This helps you to open trades that reach a certain level even when you are not there. In this, a Buy stop trade directs the broker to buy a security at a price above the current offering while a sell stop directs the broker to make a sell order when the security’s price reaches a level below the current price.