A stop-loss order is an instruction from a trader to a broker, asking them to close their position once their asset price reaches a predetermined price.
Stop-loss orders are not only tools for minimizing losses but also for locking in profits. For example, assuming that you buy a stock at $10 per share, and it appreciates to $17, you may adjust your stop loss to $15 so that in case the stock depreciates to below $10, you will have locked in a profit of $5 per share.
Traders prefer stop-loss orders due to the orders’ ability to minimize losses. Therefore, traders can pre-determine the number of losses they are willing to take. Many trading platforms provide the automation of stop-losses, thereby enabling traders to concentrate on other productive activities without worrying about the market.
Where to put stop loss levels
Below are three of the most popular strategies used by traders to determine the appropriate levels for putting their stop loss.
- Work with the market psychology and do not try to beat the market: You should study the market’s historical performance and establish the psychological support levels. Your stop loss should not be placed beyond these levels because that could potentially magnify your losses if the market goes against you. For instance, if a stock is currently trading at $105 per share, then $100 would be an excellent level to put your stop loss.
- Apply the Fibonacci retracement tool to help determine the potential breakout levels: The critical levels are 61.8%, 50.0%, and 32.5%. Therefore, if the current price is at 61.8%, you should place your stop loss at the level corresponding to 50.0%.
- Develop an appropriate risk management plan: For example, if you decide to risk 2% on a given trade, you are willing to take a loss of not more than $20 for a $1,000 investment. Therefore, you should place your stop loss at the level corresponding to the 2% loss. Sticking to the plan will help you minimize your losses.
Purpose-driven stop losses
As a trader, you may, at times, stop-loss decide to conduct your trade guided by certain predetermined thresholds. Therefore, you can use the types of stops discussed below to help you achieve your trading goals.
This is a type of stop placed based on the percentage of equity. It is a way of protecting your account from uncontrolled losses while maintaining a decent amount of capital to trade with once the market becomes profitable for you. For example, if you have a forex trading account with $10,000, a 2% equity stop loss would close your open positions if the account depreciates to $9800.
In this type of stop loss, a trader may choose to use one of the two key approaches. Firstly, they may choose to have a dynamic stop loss which will adjust according to changing market fundamentals or technical breakouts.
Alternatively, they may employ technical analysis indicators such as Fibonacci levels to help them monitor and adjust their stop loss levels from time to time as long as the losses are within their preferred maximum amount. In this case, the trader will close their position once the stop loss goes beyond their preferred maximum.
This stop is applied by traders when they think their strategy will succeed unless the market experiences volatility. One of the tools you can use is the Volatility Indicator Index. With such a tool, your stop-loss order will only be triggered once there is evidence of market volatility. In the absence of volatility, the other triggers of price oscillations will be ignored.
A volume stop functions on the same principle as the volatility stop discussed above. It is premised on a trader’s confidence that his current position will remain profitable as long as the traded volume does not drastically change. Therefore, the trader will hold on to their current position but will interpret a drastic change in volume as a signal for an impending reversal of trend or a breakout. Consequently, they will close their position.
This type of stop order is used by a relatively small number of traders, who, for the most part, are fundamental analysts. An event stop ignores the usual price action, based on what the trader believes is a probable event that can significantly influence the market. Therefore, the trader will not execute a stop loss until the event comes to pass.
Usually, the strategy works with a timeline within which the event is supposed to happen. Traders may decide against using the event stop if the market fundamentals remain unchanged during the waiting period.
Types of stop-loss orders
1. Trailing stop
This is a stop loss that is dynamic and tracks the price movement while locking in the profits or taking the loss made. The stop loss is placed at a predetermined percentage below the market price and will therefore move up and down with the price action. The profit you make will be directly proportional to the margin between the stop loss level and the current market price.
2. Market order
As you may probably deduce from the name, a market order is an order that instructs the broker to buy or sell at the current market price. It is recommended to use this type of order when you believe that the asset’s buying or selling price is appropriate. It is also preferred when you mean to trade immediately.
However, market execution has its pros and cons. One of its downsides is that you cannot always count on closing your position at specific prices as the market price will almost certainly move during the period between issuing and executing the order.
3. Limit order
This type of order specifies the upper and lower limit prices for buying and selling securities. When selling, this order specifies the minimum amount a trader is willing to be paid. When buying, it tells the broker the maximum amount he should pay for the security.
Therefore, a trade with a limit order will not be executed until a specified minimum or maximum price is met. This tool is appropriate when you believe that you can buy or sell at a better price than the current market price.
Stop-loss orders are invaluable parts of trade management in general, as well as risk management strategies. There are several ways you can place these orders, stop-loss, and you should work with the ones that best suit your style of trading and also align with your profit targets.