The ultimate goal for any trader is to make a profit while trading. However, about 90% of active traders today are unsuccessful at the venture. That is why managing losses is critical to the success of any trader.
Now there are several reasons why traders frequently return losses from their trades. One of the standout causes is a flawed exit strategy. You may nail your entry into the market, but once you are unsure of when to sell, you lose control of your trade. This is where the stop-loss order helps save the day.
In essence, the stop-loss will lead to your exit from the trade once the market begins to move unfavorably to your strategy. It forms a crucial part of any exit strategy and goes a long way in guaranteeing steady returns against minimal losses.
While trading, it is essential that you protect your position and the stop-loss order is just the tool you need. So read on and discover this crucial trading tool.
What is a Stop-Loss Order
The stop-loss order is a type of market order that exits your trade once the market price satisfies the exit condition. Stop-loss orders are aptly named as they prevent your trade from accumulating additional losses as asset prices drop.
Usually, traders set orders as part of their exit strategy from the trade. For instance, if you buy an asset for $30 and set the stop-loss at $29.50, the order will activate at $29.50. therefore, you don’t run the risk of your asset’s value going below the $29.50 mark.
The stop-loss is designed to protect the trader from additional losses that arise when the market trend declines. Just like its name goes, this order stops losses from rising. The order will be valid until you decide to liquidate your position or cancel the order altogether.
So for part-time traders, you do not have to sit in front of your computer all day watching the price fluctuations. Moreover, this order monitors the market for you and protects your position while you go on with your routine activities.
The Significance of Stop-Loss Orders
Stop-loss orders were designed to protect traders from further loss-making in an unfavorable market environment. Once you have an exit strategy in place, you can rest easy knowing that in case of a drop in prices, your stop-loss has your position covered.
As such, trading becomes more effortless in the long run. With a stop-loss in place, you free yourself to engage in other activities or even trade some more. Having this order in place takes away the need to monitor market behavior constantly.
The stop-loss is automated and, unlike you, won’t tire after staring at the screen all day. Having a stop-loss on hand is merely convenient for active traders or those who are occupied in other matters.
Additionally, stop-loss orders eliminate some aspects of emotional trading. Trading and greed have long been interlinked. Today, there is an unhealthy number of people who believe trading is a sort of get0-rich-quick-scheme. Some people get rich overnight from trading; others achieve such wealth over time. Nevertheless, the vast majority make losses primarily because of greed.
A stop-loss helps traders manage their emotions while trading and, as a result, protect not just their position but also their investment. Before engaging a stop-loss, you first have to configure it at a logical market position. So as the market decline, once your asset attains the set price, the order terminates the trade, and you can liquidate your position.
On the flip side, without a stop-order, you wouldn’t know exactly when to exit the market. Chances are you are going to wait out the declining trend in the market hoping for favorable prices. However, this could prove costly since your position loses value day by day, and you will eventually be forced to concede at a loss.
Traders rarely ever trade without a stop-loss order. Since they come at no cost at all, make sure you have one in place. Think of the order as an insurance policy in which you determine the buyout clause without added costs.
Now different trading strategies work differently. Stop-loss orders are prevalent for those who buy intending to turn a profit from the asset in due course.
Others seek to establish their presence on the market by anticipating the long-term increase in a stock or other asset. Either way, a stop-loss order will work differently for various strategies. What is important is sticking to your trading strategy. The order guides you through the trading plan by discounting emotions while trading.
The regular stop-loss orders are meant to protect you against accumulating losses. However, you can use the order to protect your profits from a trade in the form of a trailing stop-loss.
The trailing stop usually is fixed below the prevailing market price of an asset. The trailing stop will then lie above your entry price and further adjust as the price fluctuates. This fluctuation triggers once the cost equals or surpasses the level initially set.
Once the value of an asset appreciates, you potentially are making profits. However, this unrealized gain only comes into effect once you cash in. With a trailing stop, you can guarantee significant capital gains while protecting your profit.
For example, when you acquire assets worth $2 and their value shoots to $7, setting a trailing stop at $5 will protect your profits worth $3. So even if the price returns to the initial $2, you will still have made a tidy $3 from the trade.
At the same time, the stop-loss order is still active and will only activate once the trigger price is attained.
Another market order similar to stop-orders is the limit order. A stop-loss will usually go with the price nearest to your order. This is because they are designed to form part of your exit strategy.
On the other hand, limit orders operate with much precision. Once the stop-loss point is reached, limit orders will cause the trade to close at the limit price then sell or buy depending on the market price.
You can place a buy limit order when you want to buy at the limit price or lower and a sell limit for when you want to sell at the limit price or higher.
A ‘buy limit’ is placed below the current price. Once the price reaches this point or goes lower than this, you can buy into the market. The market then rises, and your asset’s value appreciates.
On the other hand, the ‘sell limit’ price lies above the current price. The value climbs up to this point and then falls. The sell limit points out when the time is right to sell before the market adjusts.
How to place your stop-loss
When placing your stop-loss, consider the market level your trading signal would need to be discredited. Before arriving at this logical level, give the market leeway while studying its trajectory in line with your trading strategy.
It is important not to set your stop-loss too high lest the market moves past it and with it, your money. Having control of your trading moves defines successful traders. The stop-loss order enables you to keep a tight hold of your account by mitigating against a market that moves out of sync with the initial plan.
Another consideration you have to make regarding your stop-loss placement is the general market conditions. A lot of people often discredit the market environment when using stop-loss orders and instead focus on the expected gains.
On the flip side, however, your trading signal should primarily dictate where the stop-loss should lie. Also, take into account the prevailing market conditions such as trading volume. As such, first define your stop-loss position, after which you can decide how large a position you would want to hold.
Most importantly, your stop-loss should mainly be deduced from logical analysis. Trading, under the influence of human emotion, is a futile endeavor. Greed shouldn’t dictate your stop-loss placement because you run the risk of significant loss-making.
Nevertheless, once you define your stop-loss placement, you can then find a reasonable profit target in the form of a take-profit order.
Your exit from a trade usually marks the successful end of your interaction with the market. Typically, traders will exit the market once they have attained their goals. These may be in the form of set targets before entering the market.
In the case of profit, it is more sensible to sell once you have gathered a respectable profit. Waiting out for far too long in the hope of much larger profits is a move driven by greed. Since trading and emotions shouldn’t be mixed, you will eventually lose out once the market reverses.
Alternative Guidelines for Placing a Stop-Loss Order
Technical indicators are popular tools used when analyzing the market and deciding when to trade. Therefore, they go hand-in-hand with stop-loss orders, and some may function as the order itself. For indicators giving buy signals, a stop loss will lie where the index no longer produces those signals.
Volatility also comes into play when determining the appropriate stop-loss positioning. Market volatility affects trends in market prices. Highly volatile markets have equally varying prices and, as such, are difficult to predict.
Volatility indicators go a long way in determining the degree of price movement over time. As such, traders can set their stop-loss based on volatility outside the range of market fluctuations.
Shortcomings of Stop-Loss Orders
Stop-loss orders lend trading a form of automation as traders do not have to be glued in front of their screens, monitoring the price action in the market. However, their much sought-after mode of operation is also their undoing.
Stop-loss orders activate once the price arrives at the order point. The order won’t be able to recognize short-term fluctuations from long-term price changes. A minor flux in the market could, regardless activate the order and needlessly close the trade.
Stop-loss orders fare poorly in fast-moving markets. As stop-loss orders switch to market orders, they often attract prices that differ from the initial stop price. In rapid markets, prices fluctuate by the minute, and the resulting market order may bring in dismal returns once activated.
In the case of limit orders, you benefit from the guarantee that your trade will only activate once the limit price is reached. However, in most instances, this limit may never come to fruition. You will then be obliged to hold out in the market until prices become favorable.
Trading Plan and Stop-Loss Order
Your stop-loss order should form part of your exit strategy and, ultimately, your trading plan. As explained above, you ought to place your stop-loss at pre-defined points on your chart. Randomizing these points goes against the whole idea of having a trading plan and will eventually yield losses.
Think of your stop-loss placement as a strategic move and should be backed by a solid plan. Your trading plan will outline your entry and exit strategy as a part of your larger trading objective. How much money you stand to make is inconsequential when determining your stop-loss placement.
There is so much more to trading than merely realizing profits. Managing your losses protects your account from unnecessary shortfalls that emerge from the absence of a solid exit strategy.
As you learn the ropes around trading, you will, sooner or later, encounter losses. The key to ultimate success in trading is learning to keep these deficits at the minimum, and market orders like the stop-loss come in handy when mitigating against excessive losses for a deteriorating asset price.
A stop-loss order also works to protect your earnings from a deteriorating trade. In the case of a trailing stop-loss, you are sure that even if an appreciated price does fall, the profit you generated from its prior rise in value will still be on hand once you exit the trade.
So finally, stop-loss orders are crucial to trading success and since they do not come at a cost, traders are encouraged to make full use of them.