Risk management is an important concept in day trading and investing because of the substantial risks involved. It is so vital since any trade that you execute has a 50-50 chance of being profitable.
One important concept in risk management is known as using a stop-loss, one of the most useful orders in trading. In this article, we will look at everything you need to know about a stop-loss.
What is a stop-loss?
A stop-loss is a tool that automatically stops a bearish or bullish trade when it reaches a certain loss threshold. For example, assume that a stock is trading at $10 and you decide to buy it. In this case, your trade will be profitable as long as the stock is above $10.
In this case, you can decide to protect the trade by placing a stop-loss at $8. As a result, if the stock drops to $8, the broker will automatically stop it. In this case, you will be safe if the stock continues dropping below $8.
Stop-loss vs a trailing stop
Another important concept is known as a trailing stop. This is a tool that solves a key challenge that a stop-loss has.
This challenge happens where a profitable trade suddenly turns unprofitable. For example, you can execute a buy trade at $10 and set a take-profit at $14 and stop-loss at $6. In this case, the trade can work and the stock can rise to $13 and then dip suddenly to $6. In this case, the original profits you generated will not count and your trade will have made a loss.
A trailing stop solves this challenge by ensuring that the original profits are not lost when the stock falls hard.
Rules for using a stop-loss
There are several rules to remember when using a stop-loss. First, always ensure that you have set the stop-loss at the right place. Doing that will help you not make the mistake of setting a stop-loss where it is not needed.
Second, always stick with the stop-loss and don’t adjust it during a trade. This is where people go wrong. They set a stop-loss and then adjust it if the trade is making a loss. They hope that the trade will have a turnaround and move towards profitability.
Third, in most cases, for the benefits we have mentioned above, use a trailing stop-loss instead of a normal stop instead.
What is a take-profit?
The concept of a stop-loss is similar to that of a take-profit. A take-profit is a tool that automatically stops a trade when it reaches a certain profit threshold.
For example, in the example above, you can place a take-profit at $12. In this case, the broker will automatically stop the trade when it rises to $12. Most successful traders always use a stop-loss and a take-profit in all their trades just to be safe.
At times, these stops will often work against them. For example, if a stock drops to the stop-loss and then resumes the bullish trend, you will miss that opportunity.
A good example is what happened during the 2010 flash crash. At the time, stocks crashed hard and then resumed a strong bullish trend. As a result, trades that were stopped using a stop-loss lost the opportunity of the bullish trend that emerged.
At the same time, if a stock moves to the take-profit and then continues rallying, it means that a trader will have lost an opportunity.
How to set a stop-loss
There are several approaches to determining where to set a stop-loss. One of the most popular approaches is to determine your risk-reward ratio and then use it to set the stop-loss.
For example, most people have a rule that they should not lose over 5% of their accounts in a single trade (the most conservative choose 2%). Therefore, if you are opening a single trade, you should always ensure that the maximum drawdown you can have is 5%.
For example, assume that a stock is trading at $10 and you have $100,000 in your account. In this case, 5% of these funds is $5,000. Therefore, when you open a trade, you should set a stop-loss at a location where the maximum loss is this amount.
This is the simplest method of calculating a risk-reward ratio. Some traders use a more complex process that incorporates their historical performance and the ratio between winning and losing trades.
Another rule when setting up a stop-loss is that it should not be extremely close to the opening price. The reason for this is that an asset tends to waver after execution. As a result, when you set up extremely close, it will likely be executed and make you to lose money.
Stop-loss for traders vs investors
A common question is whether a stop-loss should apply to both traders and investors. For starters, there is a wide difference between the two. A trader is someone who opens trades and holds them for a few hours. On the other hand, an investor buys an asset and then holds it for a few days, months, or years.
The two types of participants should always have risk management strategies. However, at times, an investor should be careful about using a stop-loss.
For example, if they initiated a buy trade at $10 and they hope that it will rise to $15, setting a stop-loss at $8 can be a bit risky since the shares has a high possibility of falling before continuing the bullish trend.
For traders, on the other hand, a stop-loss is a must for all trades to protect the potential downside.
In this article, we have looked at one of the most important topics in risk management. We have explained what a stop-loss is and some of the top rules to use when using the tool.
External useful resources
- Stop Hunting In Trading Exists, But It’s Not What You Expect It To Be – Tradeciety