Technically speaking, a stop loss is a limit order, to buy or sell, sent to his broker at the same time as the entry level of the transaction (entry level or entry point).
In practice, when a trader takes a position on a financial instrument, whether he decides to go long or short, he simultaneously sets a limit price level opposite to the direction he is betting on, in which case the position is automatically closed by the broker.
If the trader is placed in a buy (long) position, the stop loss is for a sell (short) order set at a price level below the entry point of their position. Conversely, when the operation on a financial instrument is bearish (short), the stop loss concerns a purchase (long) of the instrument and will be set at a price level higher than the entry level.
Stop loss is a tool that all traders should use constantly in their trading activity. This becomes even more important when one is inexperienced and approaches online trading for the first time. The trader, before even thinking about the potential gains he can make from his trades, must focus on what he can lose in each of the trades he makes in the markets.
The objective of Stop Loss
A priori, the trader does not know if his intuition on the market will turn out to be correct, so he sets a limit price level to protect himself if the market moves in the opposite direction to his trade. The main objective of the stop loss is to close the position with an established loss before entering into a position, in accordance with its trading plan and strategy.
Clearly, behind taking a position in one direction or the other (long or short), there is an analysis (technical or fundamental) carried out by the trader. Any strategy that can be implemented in the financial markets, whether statistical or otherwise, will, over a fairly wide range of transactions, give results that will sometimes be positive and sometimes negative.
Financial markets are impossible to predict, so any trader, regardless of experience, can end up on the wrong side of a move. It is therefore an essential tool in the toolbox of any trader in the financial markets.
The best solution is therefore to have this safety mechanism to apply in case the desired direction of operation turns out to be wrong. In this way, the maximum potential loss can be limited .
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Stop loss: where and how to place it?
In order to understand where to place the stop loss, one must first know which direction one hopes prices will go in the future. The invalidation level of the strategy must then be positioned on the opposite side. An example will clarify what has been said so far.
Practical example:
Suppose you have performed an analysis on Bitcoin. According to your studies, prices should increase soon. Currently, Bitcoin stands at $29,500. We therefore decide to set up a long strategy based on current prices (entry order “at the market”). At this stage, it will also be necessary to place stop losses to protect our capital if prices were to move in the opposite direction.
Also based on our analysis, we decide that the $29,000 level is the level at which, if crossed on the downside, would invalidate our bullish view on the exchange rate. The stop loss should therefore be placed at this level. So now we have the entry level at 29,500 and the stop loss level at 29,000.
This way, if all goes well, the Bitcoin price will rise, allowing you to make a profit, but if the prices touch the stop loss level, the position will be closed at a loss and you will avoid the risk of suffering a loss . greater loss than you had pre-determined before making the trade.
The example above is for the cryptocurrency market, but the concept remains the same whether you want to trade stocks, commodities, or stock indices.
What are the different types of Stop Loss?
There are several criteria for placing a stop loss, but there is no universal or best way to do so. The important thing is to understand the risk you are taking on once you have chosen where to place the stop loss.
There are different types of stop loss, the main ones being:
- The percentage stop loss which involves exiting the position after it has moved in the opposite direction by a percentage predetermined by the trader.
- A monetary stop loss is a type of order based on the monetary loss incurred in a particular trade. For example, the trader may decide to close his position after suffering a predetermined monetary loss.
- Stop loss based on chart patterns are trade invalidation levels that are based on variations of particular chart patterns (e.g. Hammer pattern, Shooting star, Engulfing, etc.)
- Stop loss based on technical levels uses static or dynamic supports and resistances to identify the most appropriate level that would invalidate our trade. This can be, for bullish strategies, horizontal supports, and for bearish strategies, static resistance levels.
- The volatility-based stop loss is the one that can be considered “safer” than the previous ones. Positioning the order based on volatility allows prices to “breathe” and avoid being stopped out prematurely due to temporary adverse price movements. This stop loss is traditionally set via the ATR indicator (an indicator that measures investor enthusiasm).
It is essential to know the basic rules to set the stop loss in a smart and profitable way.
Here are the 3 rules to set the stop loss in the best possible way.
Rule 1: Choose a specific entry price
You should never enter a trade at a random price but study an entry price and enter the market only at that point.
In this way, the stop loss can be placed a short distance from the entry point, where prices can only arrive if the analysis you had made of the market was wrong: the order therefore allows you to exit with little damage, re-analyze the situation, and possibly re-enter at a more favorable price.
Rule 2: Determine the loss threshold
You need to decide beforehand how much capital you want to risk (in terms of money). It is very important that the stop loss is lower than the expected gain from the trade: in other words, the loss exit price should be closer to the market entry price than the profit exit price.
Rule 3: Develop your trading plan before you trade
Analyze and choose entry and exit prices in advance, both for losses and for profits: each trade must take the time to study and analyze the state of the market, impulsive or uninformed entries on the market are to be avoided. The study phase must precede the negotiation phase: when you place an order, you must then be mentally free to turn off your PC and not follow the question for hours: stop losses and take-profits should give you confidence that you did the right thing, and your after-the-fact interventions may cause more harm than good .
What we remember from Stop Loss
The stop loss is one of the best allies of any trader, from the beginner to the most experienced. To be used in synergy with take profit, it is one of the essential risk management tools for any investor, to learn how to use as soon as possible. This is why we have also addressed the question from a practical point of view. , presenting some of the methods closest to the needs of novice traders, who can thus apply the stop loss to their investments in an easy and intuitive way.