Understanding stop-loss orders - Risk management basics
The stop-loss order is one of those little things, but it can also make a world of difference. Even the most inexperienced traders can benefit from this tool in some way. Read on to find out exactly what a stop-loss is and how to use one.
What is a stop-loss order?
A stop-loss order is simply an order that limits your risk by closing out your position at a small loss at a specific price. If you buy a stock at $20 and place a stop-loss at $19.50, when the price reaches $19.50 your stop-loss order will execute, preventing further loss.
Stop-loss orders are usually “market orders,” meaning it will take whatever price is available once the price has reached $19.50 (can be based on the bid, ask or last price touching $19.50). If no one is at that price to take your trade-off your hands, you could end up with a worse price than expected. This is called slippage. As long as you are trading Stocks, currencies in the Forex Market, or futures contracts with high volume, slippage while day trading isn’t usually an issue.
Positives and negatives
The advantage of a stop-loss order is you don’t have to monitor how a stock is performing daily. This convenience is especially handy when you are on vacation or in a situation that prevents you from watching your stocks for an extended period.
The disadvantage is that a short-term fluctuation in a stock’s price could activate the stop price. The key is picking a stop-loss percentage that allows a stock to fluctuate day to day while preventing as much downside risk as possible. Setting a 5% stop loss on a stock that has a history of fluctuating 10% or more in a week is not the best strategy. You’ll most likely just lose money on the commission generated from the execution of your stop-loss order.
There are no hard-and-fast rules for the level at which stops should be placed. This totally depends on your individual investing style: An active trader might use 5% while a long-term investor might choose 15% or more.
Another thing to keep in mind is that, once you reach your stop price, your stop order becomes a market order and the price at which you sell may be much different from the stop price. This fact is especially true in a fast-moving market where stock prices can change rapidly.
Not just for preventing losses
Stop-loss orders are traditionally thought of as a way to prevent losses, thus its namesake. Another use of this tool, though, is to lock in profits, in which case it is sometimes referred to as a “trailing stop.” Here, the stop-loss order is set at a percentage level below the current market price, not the price at which you bought it. The price of the stop-loss adjusts as the stock price fluctuates. Remember, if a stock goes up, what you have is an unrealised gain, which means you don’t have the cash in hand until you sell. Using a trailing stop allows you to let profits run while at the same time guaranteeing at least some realised capital gain.
Advantages of the stop-loss order
First of all, the beauty of the stop-loss order is that it costs nothing to implement. Your regular commission is charged only once the stop-loss price has been reached and the stock must be sold. You can think of it as a free insurance policy.
Most importantly, a stop-loss allows decision making to be free from any emotional influences. People tend to fall in love with stocks, believing that if they give a stock another chance, it will come around. This causes procrastination and delay, when giving the stock yet another chance may only cause losses to mount.
No matter what type of investor you are, you should know why you own a stock. A value investor’s criteria will be different from that of a growth investor, which will be different still from an active trader. Anyone strategy may work, but only if you stick to the strategy. This also means that if you are a hardcore buy-and-hold investor, your stop-loss orders are next to useless.
The point here is to be confident in your strategy and carry through with your plan. Stop-loss orders can help you stay on track without clouding your judgment with emotion.
Finally, it’s important to realize that stop-loss orders do not guarantee you’ll make money in the stock market; you still have to make intelligent investment decisions. If you don’t, you’ll lose just as much money as you would without a stop-loss, only at a much slower rate.
Where to place a stop-loss order when buying
A stop loss shouldn’t be placed at a random level. The ideal place for a stop loss is at a location which allows the market enough room to fluctuate a little while it starts to move in your favour, but gets you out of your trade if the price turns against you.
One of the simplest methods for where to place a stop-loss order when buying is to put it below a “swing low.” A swing low occurs when the price falls and then bounces. It shows the price found support at that level.
You want to be trading in the direction of the trend. As you buy, the swing lows should be moving up. The chart shows several potential entry points along with possible stop-loss locations for each entry.
Where to place a stop-loss order when short selling
A stop loss shouldn’t be placed at a random level. The ideal place for a stop loss is at a location which allows the market enough room to fluctuate a little while it starts to move in your favor, but gets you out of your trade if the price turns against you.
One of the simplest methods for where to place a stop order when short selling is to put it above a “swing high.” A swing high occurs when the price rises and then falls. It shows the price found resistance at that level.
You want to be trading in the direction of the trend. When looking for short trades the swing highs should be moving down. The chart shows a potential entry along with a possible stop-loss location for a short trade.
Where to place a stop loss – alternatives
Above a swing high when shorting or below a swing low when buying isn’t the only place to put a stop loss. Depending on your entry price and strategy, you may opt to place your stop loss at an alternative spot on the price chart.
If using technical indicators, the indicator itself can be used as a stop loss level. If an indicator provided you with a buy (go long) signal, a stop loss can be placed at a price level where the indicator will no longer signal it’s wise to be long.
Fibonacci Retracement levels can also provide stop loss levels.
Volatility is also commonly used to set stop-loss levels. An indicator such as Average True Range tells how much the price typically moves over a period of time. Traders can set a stop loss based on volatility, attempting to place a stop loss outside of the normal fluctuations. This can also be done without an indicator by measuring the typical price movements on a given day and then setting stop losses and profits accordingly.
Define your stop loss strategy
Stop-loss levels shouldn’t be placed at random locations. Where you place a stop loss is a strategic choice and should be based on testing out and practising multiple methods – finding which works best for you.
A trading plan is where you define how you will enter trades, how you will control risk and how you will exit profitable trades. Isolating the trend direction and controlling risk on trades is of paramount concern when learning how to day trade. When starting out, keep trading simple. Trade in the overall trending direction, and use a simple stop loss strategy that gives enough room for the price to move in your favor, but cuts your loss quickly if the price moves against you.
A stop-loss order is a simple tool, yet so many investors fail to use it. Whether to prevent excessive losses or to lock in profits, nearly all investing styles can benefit from this trade. 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.