A stop-loss order is a pending order that tells a broker to stop a loss-making trade at a pre-determined level.
The goal of a stop-loss order is to limit the amount of loss that a you can lose in a trade. For example, if a company’s stock is trading at $30 and you believe it will go up, you can place a stop-loss order at $25.
In this case, you will make a profit if the price moves above $30. At the same time, if it drops to $25, the trade will be stopped, limiting the amount of losses that you can make.
Risk of the unknown
A common risk in the market is that of the unknown. No one simply knows what will happen in the financial market on any given day.
For example, 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.
In early months of 2018, 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.
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.
How to use stop loss
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.
Risk Reward Ration
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.
Open Trades at certain level
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.
How to identify levels to set a stop loss
There are several strategies of identifying potential areas of having a stop loss. Some of them are:
- Always have a risk-reward ratio before you open a trade. For example, if you have a 3% ratio, it means that you can only lose $300 if you have a $10,000 account. Therefore, when you open a trade, you should always set your stop-loss where the maximum loss is $300.
- Set a stop-loss order at a psychologically-important level. For example, if a company’s stock is trading at $33 and you are long, an ideal place to add a stop-loss order is at $30. That’s because, in most cases, bears will always attempt to retest a psychological level in the market. In a similar manner, you should have take-profit at such a level.
- You should use the concept of Fibonacci retracement to set stop-loss order. For example, if the stock is trading at $30, which is the 61.8% retracement level, you can buy it and then place a stop at the $50% retracement level. This is an important location since it is a location that many paces look at.
A stop-loss order is an excellent order that allows you to stop a trade if it moves to a certain level. Its benefit is that it prevents further losses and is also an important approach to manage risk. The only drawback is when it is executed and then the financial asset reverses.
External useful Resources
- The Stop-Loss Order—Make Sure You Use It - Investopedia