A Guide to Using Stop Losses
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If you're a trader, you know that trading in the markets comes with great opportunities, as well as significant risks. You might be confident in a specific trade's profit potential only for the market to head in the opposite direction and cause you a massive loss. However, with the right risk management strategies, such as using a stop-loss, you can significantly mitigate the effects of such turns and protect your trading capital.
A stop-loss is a set floor that determines how much you can lose per trade and when your broker should pull you out of a position if the market goes against you. This helps mitigate your losses and limits them to comfortable levels. Furthermore, knowing your risk tolerance, risk-to-reward ratio, and investment objectives will help you set your stop-loss orders at the most optimal levels. This piece will explore stop-losses and how to implement them in your trades.
What are Stop-Losses?
A stop-loss is a trading tool that allows you to exit market positions at certain levels when your trades make losses. Because making a profit or loss is part of any trade, stop-losses help you conveniently manage your downside to acceptable levels. Once you place them, they remain pending and only get executed when certain events occur, which, most often than not, are prices dropping below set thresholds.
For instance, if you place a trade with company X for 100 shares at $10 per share. You can also set a stop-loss order with your broker for the same trade at $8.50, limiting your total loss to $150 if the trade goes against you. This gives you peace of mind knowing that $850 of the principal amount will be secure regardless of the hit the actual shares take.
How do Stop Losses Work?
Stop-losses work by selling a trader's instruments after they reach a predetermined price in the opposite direction from what they were expecting. This price is usually lower than what the trader paid and represents a loss. However, instead of the trader manually keeping an eye on the markets to allow them to make decisions as market conditions change or leave them unprotected. Stop-losses orders anticipate such market movements and mitigate losses when they occur.
Furthermore, you can add a stop-loss to your trade before or after placing it. The most essential thing is figuring out where to put it and placing the order. Furthermore, each trade has a risk-to-reward ratio that will help you calculate the best price to place your stop-loss order. A trade is worth making when the potential gains are more than the losses.
The Different Types of Stop-Losses
- Standard Stop-loss: A standard stop-loss is one of the most common types and is used to set a fixed-priced level your losses cannot exceed. If the price of your instrument moves as you expected or against you, the standard stop-loss will stay fixed and only get triggered if it reaches the threshold. However, you can manually move them before they are triggered to reflect the current market conditions and your risk awareness.
- Trailing Stop-loss: As the name suggests, a trailing stop-loss follows the market price from a set distance. This allows you to take advantage of a rising market by adjusting your stop-loss higher as prices increase. For instance, if your trailing stop-loss for a particular trade is $10 and the instrument's price increases by $3. Your stop-loss will also adjust by $3 to maintain the $10 distance from the current price. However, if the price reduces by the same $3, the trailing-stop loss will not adjust and will stay fixed until the price moves upwards and exceeds the $10 mark again. It will also be triggered if the price keeps falling and drops below your $10 limit.
- Guaranteed Stop-loss: Just like a standard stop-loss order, a guaranteed stop-loss set's a particular fixed exit price. However, unlike the former, you're guaranteed the exact amount of the order rather than the next best available price.
What Makes Stop-Losses Such a Key Risk Management Tool for Traders?
- They protect your trading capital by limiting losses to known and acceptable levels.
- They enable you to stick out trades and maximize your profit potential by not exiting too early.
- They help in automating the trading function and limiting emotions. Once you calculate your optimal stop-loss level, you can place your order and leave the rest to market forces.
- They enable the integration of good discipline practices into any trading strategy while reducing a trader's workload.
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