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Lesson 8: Stop Loss 

Lesson 8: Stop Loss 

To limit your risk on a trade, you need an exit plan. And when a trade goes against you, a stop-loss order is a crucial part of that plan.

Traders are urged to use stop-loss orders whenever they enter a trade, to limit their risk and avoid a potentially unwanted loss.

If you’re ready to use stop-loss orders, here are 4 steps to follow:

  1. Open a trading account to get started, or practice on a free demo account
  2. Conduct technical and fundamental analysis on the market you want to trade
  3. Pick your price level – where you want your stop loss to be triggered – and set your stop order
  4. Once you have decided the position size, place your order

For more info about how to use stop-loss orders, you can discover what you need to know in this guide.

What is Stop-Loss

As the name implies, stop-loss orders are pending orders that automatically close your position to stop a loss from getting any worse than your predetermined maximum amount you were willing to risk and avoid a stop out.

That maximum may be determined by either:

  1. Risk management considerations: broken price support of some kind or other indications that you were wrong about the price direction.
  2. Money management considerations: you don’t want to lose more than 1 to 3 percent of your account on any given trade.

There are two basic kinds of stop-loss orders:

  1. Fixed or Simple Stop Loss: As the name implies, this order automatically executes when a fixed predetermined loss is reached or if the market gaps past it, and the loss is exceeded. Any good online trading platform will allow you to set that loss in terms of pips, cash loss, or percentage loss from your entry price.
  2. Trailing Stop Loss: As the name suggests, this kind of stop-loss order trails or follows the price as it moves further in your favor, and it automatically closes your position after the currency pair price moves against you by a fixed number of pips, cash amount, or percentage change in price against you. Thus, the trailing stop loss not only to limits losses but also locks in gains from winning trades that have started to reverse against you by more than what you believe to be normal random price movements or “market noise.”

Stop-loss orders are a key part of risk management. We can enter them in advance and have our trading system automatically cut our losses. They help keep emotion out of our forex trading, stock trading, futures trading, crypto trading, and in general, any type of CFD trading.

For a given position size and leverage, you limit your maximum loss per trade through your stop-loss settings. The following rules on stop loss setting assume you’re entering near strong support because if you aren’t, you shouldn’t even consider entering the trade. If the trade moves against you, that nearby support is quickly breached, and you have a trading signal to exit before a small loss becomes a large one.

How Stop Loss orders work

Stop-loss is a stop order designed to work automatically, so you don’t have to watch the market constantly to check whether prices will move against you. This is especially useful in volatile markets when prices change suddenly, and you don’t have time to manually close out a trade that’s turned against you.

For example, a trader who buys shares of stock at $45 per share might enter a stop-loss order to sell his shares, closing out the trade, at $40 per share. It effectively limits his risk on the investment to a maximum loss of $5 per share. If the stock price falls to $40 per share, the order will automatically be executed, closing out the trade. Stop-loss orders can be especially helpful in the event of a sudden and substantial price movement against a trader’s position.

Stop-loss orders can also be used to lock in a certain amount of profit in a trade. For example, if a trader has bought a stock at $2 a share and the price subsequently rises to $5 a share, he might place a stop-loss order at $3 a share, locking in a $1 per share profit if the price of the stock falls back down to $3 a share.

It’s important to understand that stop-loss orders differ from take-profit orders (limit orders) that are only executed if the security can be bought (or sold) at a specified price or better. When the price level of a security moves to – or beyond – the specified stop-loss order price, the stop-loss order immediately becomes a market order to buy or sell at the best available price.

Therefore, in a rapidly moving market, a stop-loss order may not be filled at exactly the specified stop price level but will usually be filled close to the specified stop price. But traders should clearly understand that in some extreme instances stop-loss orders may not provide much protection.

For example, let’s say a trader has purchased a stock at $20 per share and placed a stop-loss order at $18 a share, and that the stock closes on one trading day at $21 a share. Then, after the close of trading for the day, catastrophic news about the company comes out.

If the stock price gaps lower on the market open the next trading day – say, with trading opening at $10 a share – then the trader’s $18 a share stop-loss order will immediately be triggered because the price has fallen to below the stop-loss order price, but it will not be filled anywhere close to $18 a share. Instead, it will be filled around the prevailing market price of $10 per share.

With limit orders, your order is guaranteed to be filled at the specified order price or better. The only guarantee if a stop-loss order is triggered is that the order will be immediately executed and filled at the prevailing market price at that time.

Where to Set the Stop Loss: Two Criteria

When setting your stop-loss order, you’re always striking a balance between two conflicting criteria:

  1. The stop-loss price is close enough to your entry point so if it’s hit, the loss doesn’t exceed 1 to 3 percent of your account value, as noted previously.
  2. It’s far enough away from your entry point so it doesn’t get hit by normal random price movements and close your position before the price has had time to move in your favor. Rather, it’s triggered only by price moves that are big enough to suggest that you were wrong and overestimated the strength of a given support zone, and now a loss is more likely than you thought. It’s time to close the position before a small affordable loss becomes a large one. There are different ways to determine the normal or average price movement to expect during a given period. Some manually determine the average or typical candle length over a given period. Some will use a certain percentage of the range as determined by the Average True Range (ATR) indicator. Price volatility varies with market conditions and time frame as must the distance from the entry point to stop loss.

Viewed from another perspective, setting stop losses means striking a balance between:

  1. Less frequent but larger losses from wider (or looser) stop loss settings: The farther your stop loss from your entry point, the larger the losses on losing trades relative to your gains from winning trades. However, you have less chance of having your stop loss hit before the price starts to move in your favor (being “stopped out”). The main advantage of this approach is a higher percentage of winning trades (which you may need for encouragement), at least when you’re right about the ultimate price direction. The main disadvantage is that you risk too many large losses and lower profits compared to the following approach to setting stop losses.
  2. More frequent but smaller losses from tighter (or narrower) stop loss settings: The closer your stop losses to your entry point, the smaller the losses on losing trades relative to your gains from winning trades. However, you’ll have more losses from being “stopped out” on trades that would have ultimately worked, because your stop loss will be hit more often before the price has had time to move in your favor.

More Capital Allows Wider Stop Losses

A larger account means:

  1. You can afford to set stop loss settings that are wide enough to avoid getting prematurely “stopped out,” yet still only risk 1 to 3 percent of your capital, because you have more capital to risk. That means there are more trades available to take that have entry points that are both close enough to strong support and only risk 1 to 3 percent of your capital.
  2. You can afford the wider stop losses needed to ride the more stable longer-term trends via longer-term positions. The longer you hold a position, the larger the normal price swings and the farther the stop loss must be from your entry point. A bigger account allows you to set those stop losses far enough from your entry point (near strong support for long positions or strong resistance for short positions) to ride the wider short-term fluctuations within the more predictable long-term trends.

Not surprisingly, experts suggest certain minimum account sizes that allow proper risk and money management could increase traders’ chances of being profitable.

Stop Loss Calculation

Your stop loss can be calculated in two different ways: cents/ticks/pips at risk and account dollars at risk. The strategy that emphasizes account dollars at risk provides much more valuable information because it lets you know how much of your account you have risked on the trade.

It's also important to take note of the cents/pips/ticks at risk, but it works better for simply relaying information. For example, your stop is at X and your long entry is Y, so you would calculate the difference as follows:

Y - X = cents/ticks/pips at risk

If you buy a stock at $10.05 and place a stop-loss at $9.99, then you have six cents at risk, per share that you own. If you short the EUR/USD forex currency pair at 1.1569 and have a stop-loss at 1.1575, you have 6 pips at risk, per lot.

This figure helps if you want to let someone know where your trading orders are, or to let them know how far your stop-loss is from your entry price. It does not tell you (or someone else) how much of your trading account you have risked on the trade, though.

To calculate how many dollars of your account you have at risk, you need to know the cents/ticks/pips at risk, and also your position size. In the stock example, you have $0.06 of risk per share. Let's say you have a position size of 1,000 shares. That makes your total risk on the trade $0.06 x 1000 shares, or $60 (plus commissions).

For the EUR/USD example, you are risking 6 pips, and if you have a 5 mini lot position, calculate your dollar risk as:

Pips at risk X Pip value X position size

OR

6 pips at risk X $1 per pip X 5 mini lots = $30 risk (plus commission)

Your dollar risk in a futures position is calculated the same as a forex trade, except instead of pip value, you would use a tick value. If you go long E-Mini S&P 500 at 1254.25 and place a stop-loss at 1253, you are risking 5 ticks, and each tick is worth $12.50. If you buy three contracts, you will calculate your dollar risk as follows:

5 ticks X $12.50 per tick X 3 contracts = $187.50 (plus commissions)

Control Your Account Risk

The number of dollars you have at risk should represent only a small portion of your total trading account. Typically, the amount you risk should be below 2% of your account balance, and ideally below 1%.

For example, say a forex trader places a 6-pip stop-loss order and trades 5 mini lots, which results in a risk of $30 for the trade. If risking 1%, that means they have risked 1/100 of their account. Therefore, how big should their account be if they are willing to risk $30 on a trade? You would calculate this as $30 x 100 = $3,000. To risk $30 on the trade, the trader should have at least $3,000 in their account to keep the risk to the account at a minimum.

Quickly work the other way to see how much you can risk per trade. If you have a $5,000 account you can risk $5,000 ÷ 100, or $50 per trade. If your stop-loss is 25 pips, you’ll only use 0.2 lots in your trade.

If you have an account balance of $30,000, you can risk up to $300 per trade (though you may opt to risk even less than that). If your stop-loss is 30 pips, you’ll open 1 lot.

Advantages and disadvantages of using Stop Loss orders

The most important benefit of a stop-loss order is that it costs nothing to implement. Your spread is charged only once the stop-loss price has been reached and the trade must be closed. One way to think of a stop-loss order is as a free insurance policy. The main disadvantage is that a short-term fluctuation in a security's price could activate the stop price.

Benefits of using stop orders

  • Stop-loss orders limit your risk of loss without limiting your potential for profit
  • Because stop-loss orders are triggered automatically, you don’t constantly have to monitor your open positions
  • They can also help you trade smarter, limiting the risk of emotional influences, as setting your stop-loss automates when you’ll exit an unfavorable trade

Risks of using stop orders

  • If an unfavorable market movement is temporary – say, for instance, a ‘dead cat bounce’ occurs for an asset you’ve gone short on – you can lose future profits when the temporary unfavorable movement triggers your stop loss
  • Setting a normal stop-loss is no guarantee that your stop loss will be executed at that exact level. If the market moves suddenly past the point at which your stop loss has been set, it could be fulfilled at a worse price than your stop loss amount. Therefore, guaranteed stops are used – to prevent negative slippage

Final words about Stop Loss and Trailing Stop

A stop-loss order is a simple tool that can offer significant advantages when used effectively. Whether to prevent excessive losses or to lock in profits, nearly all trading styles can benefit from this tool. Think of a stop-loss as an insurance policy: You hope you never have to use it, but it's good to know you have the protection should you need it.

Free trading tools and resources

Before you start trading, you should consider using the educational resources we offer like CAPEX Academy or a demo trading account. CAPEX Academy has lots of courses for you to choose from, and they all tackle a different financial concept or process – like the basics of analyses – to help you to become a better trader.

Our demo account is a great place for you to learn more about leveraged trading, and you’ll be able to get an intimate understanding of how CFDs work – as well as what it’s like to trade with leverage – before risking real capital. For this reason, a demo account with us is a great tool for investors who are looking to make a transition to leveraged trading.

Frequently Asked Questions (FAQs)

What is a trailing stop-loss order?

A trailing stop-loss order is a stop-loss that moves with the security to the trader's benefit. Instead of a set stop price, a trailing stop's price is relative to the security. For example, a trader may hold stock at $2 and place a trailing stop-loss order of $0.50. If the stock drops to $1.50, then the stop price is hit, and the order triggers. If the stock rises to $3, then the stop level increases to $2.50. This essentially allows traders to automatically lock in more gains while keeping the relative stop level in place.

What is a good stop-loss order?

The 2 percent rule states that you should stop a loss when it reaches 2 percent of starting equity. The 2 percent rule is an example of a money stop, which names the amount of money you're willing to lose in a single trade.

What is the difference between a stop-loss and limit order?

Stop-loss and stop-limit orders can provide different types of protection for both long and short investors. Stop-loss orders guarantee execution, while stop-limit orders guarantee the price.

Do stop losses always work?

No, stop losses do not always work. Although they manage to prevent big losses in normal market conditions, they are by no means bulletproof. Some examples of when setting a stop loss will not help at all, include market lockdowns, extremely low liquidity, and when the market gaps against you.

Do professional traders use stop losses?

One of the main reasons professional traders don't use hard stop losses is because they use mental stops instead. The advantage of this is that you don't have to 'give away' where your stop loss is by placing it in the market.

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