By using a stop loss we can maximize our risk per transaction. The use of a stop loss is therefore an important part of risk management in trading.
How do we actually use a stop loss and is it also possible to trade without a stop loss? In the article below we discuss both questions and offer a full explanation of this essential trading tool.
What is a stop loss?
Stop loss is a basic term in trading forex and CFDs. A stop loss is an automatic order that a trader uses to limit the maximum loss on a running position. In short, a stop loss is a kind of confession. A trader confesses by placing a stop loss that there is a possibility that the market can also move in the opposite direction. The stop loss level determines the extent to which the trader is prepared to allow the loss to increase.
Why use stop losses?
A stop loss is often seen as the only effective tool against losing money and is an absolute risk limitation. Many traders swear by the use of a stop loss and claim that a badly placed stop loss is even better than not placing a stop loss at all.
Advantages of a stop loss
After placing a stop loss, there is no longer any need to constantly monitor the market. This is a big advantage since only a few traders have the time to sit in front of a computer screen all the time.
Another advantage of using stop orders is that they prevent emotional trading. By setting the exit level in advance we make sure that we stick to our trading strategy, without the risk that we ourselves adjust the position manually.
Successful trading is difficult without a good trading plan. The use of a stop loss is an excellent tool for determining and capturing the maximum risk that we want to take per transaction.
Disadvantages of the stop loss
The use of stop loss orders can also have disadvantages under certain circumstances. Especially placing a stop loss on the wrong stop loss distance can cause problems. We will come back to this later.
In addition to a good knowledge of the normal level of market movements, the degree of volatility is important. Heavy volatility sometimes occurs and is difficult to estimate. Volatility can cause stops to be triggered more often. Many brokers use a so-called minimum stop distance. This is intended to prevent you from placing a stop that is too close to the entry level of an order. A minimum stop distance can have both advantages and disadvantages. Traders who have a so-called scalping strategy should choose a broker who does not set any conditions with regard to a minimum stop distance.
The use of stop loss orders can lead to costs. The use of a normal stop loss is free of charge with many brokers. The use of so-called guaranteed stop orders, however, is often subject to a stop loss premium or commission if the stop level is hit.
Stop loss vs stop limit
Many brokers use the terms stop loss and stop limit within their trading platform. The terms look the same but there is a clear difference.
Stop loss
Imagine having a long position on the German DAX30, at a current level of 12,400 points. Your entry level was 12,185 points and your goal is a level of 12,500 points. You want to protect a part of your profit and avoid making a loss. You place a stop loss at 12,300 points. If the DAX30 falls to a level of 12,300 points, your position is automatically closed. In this example, your profit is 115 points.
Stop limit
What is a stop limit order? A stop limit order is a conditional (pending) order and is a combination of two orders; the stop loss and a limit order. With a stop limit order we need to enter a stop price and a limit price.
Imagine that the Covestro share (DAX30) is currently trading at € 47.00. You expect the value of the share to fall further and want to place a short order. However, you want the order to be executed when the stock reaches the value of € 46.00 and you want to close your position as soon as the stock has fallen through the € 43.00 limit. You set a stop limit order at € 46,00 and a stop loss at € 43,00. When the stock reaches the value of € 46.00, the order is automatically executed with a target price of € 43.00.
Guaranteed stop loss vs non-guaranteed stop loss
The difference between a guaranteed stop and a non-guaranteed stop is related to the execution level. When placing a normal or non-guaranteed stop, there is no guarantee that the broker is actually able to close a position at the desired execution level. This is due to volatility and price gapping.
What is a price gap in trading? A price gap is the distance that can occur between a closing price and the subsequent opening price. A price gap can occur on a daily basis in equity markets. Every stock investor knows that the opening price in the morning often differs from the closing price of the previous trading session. Occasionally, it also happens that the trading of a certain share is temporarily halted. When trading resumes, we often see a very different price.
Price gapping in forex markets often occurs during the weekend. This concerns the difference in the closing price on Friday evening and the opening price on Sunday evening.
Guaranteed stop loss
With a guaranteed stop loss, the broker guarantees the execution level. A guaranteed stop loss therefore offers protection against price gaps. If the next available market price exceeds the stop loss level, you will not be affected. Brokers charge for the use of a guaranteed stop loss. Pay close attention when these costs are charged. Sometimes costs are only charged when a guaranteed stop level is actually reached, but sometimes costs are already charged when the guaranteed stop level is entered.
How do we use a stop loss?
Setting up a stop loss when trading CFD’s or forex doesn’t have to be difficult. It’s mainly about where we place the stop loss. In order to be able to determine this we need some knowledge about calculating a stop loss. A stop loss should be placed at a logical level, which is related to our analysis or the movements in the market. As indicated we use the stop loss level to determine to what extent we are willing to make a loss.
Of course it is also possible to manually close a trade when it is on a losing position. The risk here is that we close a position for emotional reasons, without adhering to a trade plan or a pre-defined stop loss level. It is also possible that the fear of loss causes us to close our position prematurely. Placing an automatic stop loss prevents the above problems.
By placing a stop loss we stay in position, as long as the set-up of the trade and the trading direction prove to be correct. At the same time, the stop loss ensures that we stick to our trading plan. In case of trading and day trading we often look at support and resistance lines to determine a stop loss. These are an excellent way to generate signals that indicate that our trading idea is no longer valid. To determine our stop loss, we identify nearby expected price or price levels if the market is moving in the opposite direction. Calculating the stop loss is a combination of the space we want to give the market to recover and the maximum loss we want to take on a position.
A common mistake is that when placing a large position trader’s place the stop loss very close to the entry level of the transaction. In this way the position will not have any room to recover in the desired direction after opening.
A second common mistake is to place a stop loss based on the money one expects to win or lose. It is better to look at the market conditions and the indicators used to generate the trading signal.
It is clear that only an automatically placed stop loss will lead to objective trading.
Stop loss strategies
As we mentioned at the beginning of this article, the use of stop losses is an essential part of risk management when trading CFDs and forex. We all have the same goal when trading, which is to make a profit. Trading and day trading, however, are risky. So we need to make sure that we maximize our risk. The use of stop losses and take profits is the solution to this.
The way in which we maximize our risk can vary from person to person and from market to market. What risk are we prepared to take on each transaction? And what is the volatility in the market in which we trade? The standard volatility in a market can often be determined by means of an indicator. A so-called volatility index is also available for many large indices. What type of stop loss order do we place with our transaction? A regular stop, a guaranteed stop or a trailing stop?
Trailing stop
What’s a trailing stop? A trailing stop is a stop loss order that moves with a position. The aim of a trailing stop is to limit losses and maximize profits. A trailing stop loss follows the price and adjusts as long as the trade moves in the desired direction. A trailing stop is expressed as a percentage or a fixed price relative to the market price.
Trailing stop example
We propose to go long on the ABC share, at a level of € 20.00. We want to be able to take advantage of price increases and make no more than 5 percent losses. We place a trailing stop at a price of € 19.00. The position will automatically close when the share price falls 5 percent below the market price.
When the share price rises, the trigger price for the trailing stop will automatically rise. For example, if the price of the share rises to € 30.00, the trailing stop will only be executed when the price of the share drops below € 28.50 (5 percent below the market price).
The exact location of a stop loss depends on the technique we want to use for this purpose. A stop loss can be placed at a fixed level, by means of an indicator or by means of trading times. Of course a stop loss can also be placed at random.
Time-based stop loss strategy
In the case of a time-based stop loss, the stop is based on the trading time frame. For example, a stop is placed at the bottom or top of a specific candle, the most recent low point being the stop loss level. A time-bound stop loss is suitable for volatile markets.
Stop loss in case of volatility
Knowledge of the volatility of the market being traded is very important. The degree of volatility determines where a stop loss can be placed. This can be a stop loss at a fixed level, or a stop loss that is determined on a percentage basis. The use of a fixed stop loss can cause the stop loss to be executed at a worse level than desired, or at short-term price fluctuations.
A percentage determined stop loss level is a good solution for many trading markets. As indicated above, a so-called volatility index is available for many markets, so that the volatility is known within a certain time period. In this way we are able to place the stop loss in such a way that it has the possibility to move along with price fluctuations in the market. Of course it should be noted that market conditions are not always predictable.
Swing trading stop loss strategy
What is swing-trading? Swing-trading is trading in the medium term. Swing-trading offers a little more possibilities to manage a stop loss. With a swing trade, a position is held longer than with day trading or scalping. It is therefore especially important to look at the maximum loss we want to sustain on a trade. Even with a swing-trade we may not be able to constantly monitor the market. The use of an automatic stop is therefore still a good option.
Scalping stop loss strategy
What is scalping? Scalping is a trading strategy in which traders try to take advantage of small price movements. The starting point for scalping is technical analysis. A scalper follows the market constantly. As a result, scalpers may make less use of a stop loss. However, the use of a stop loss is also useful for short-term trading. Think of the use of a stop loss for news trading or in case of important interest rate decisions.
Day trading stop loss strategy
In day trading or intraday trading, the use of a stop loss is a valuable tool that protects us against increasing losses. We are now familiar with the different ways in which a stop loss can be placed. The question always remains how much you are prepared to risk per trade.
The 2% rule in trading
A particular point of attention is the so-called 2 percent rule in trading. According to the 2% rule, a trader may only risk 2 percent of the total available capital per transaction. The 2% rule is part of the risk management in trading and for many traders it is part of their trading plan.
When a trader strictly applies the 2% rule, it will prevent traders from losing the balance on their account quickly. There are many possible variations on the 2% rule. Depending on the chosen trading strategy larger or tighter parameters are possible. It is important that a trader feels comfortable with the chosen level.
Conclusion
It will be clear that the use of a stop loss can help traders in making better decisions. Nevertheless every trader will have to decide for himself in which way a stop loss can best be used. It is advisable to include the method you choose in your trading plan.