A stop loss is a market order that helps limit the drawdown while trading the financial industry. These kinds of orders execute when the price goes against the desired buy or sell position. As soon as the asset reaches the designated level, your exit order converts into a market order. For example, you can place a stop loss at a certain level beneath to protect a long entry, according to the risk appetite, carried out at the next best opportunity.
Types of exit orders
The sole purpose of stop-loss orders is not limited to maintaining risk only. One can use them to open new positions both ways. We can classify such orders into the following types:
- Buy stop. An order that opens a new trade on the long side and is placed above the current price of an asset. Some traders may also use such kinds of stops to hedge out on losing short positions.
- Sell stop. It is the complete reverse of the buy stop where the order is at a position below the security’s current price. Similarly, such exit commands are beneficial for hedging out of losing long trades.
- Buy limit. A type of order placed below the current price of an asset which triggers a long position as it hits.
- Stop limit. An order placed above the current price of an asset triggering a short trade as it hits.
- Trailing stop. One of the distant relatives of stop loss. As the name indicates, this type of order trails as the position goes into profit.
- Mental stop. Pro traders mostly utilize such kinds of orders. They are similar to a standard stop loss. The difference is that you don’t have it on the platform; instead, it’s in your mind. Institutional traders remove their trades once they see it is not working in their favor, and the process is all in their brain.
Image 1: A buy stop order is placed above the price on the MT4 platform.
Market orders execute as soon as the price hits them, while limit or stop loss allows you to name your execution price.
What are the benefits of using stop losses?
Stop losses can be a significant factor in turning around the loss rate of traders.
One of the top benefits of exit orders is limiting the losses. They can prevent substantial drawdowns by cutting off the position before it reaches a point of no return.
Stop-loss is a way to ensure that your profits are locked. Trailing stops are especially beneficial in this regard. As the position moves in your favor, you can move the order near the price value. If the market chooses to reverse, your SL hits; however, profit will be at your disposal as the asset is in the positive territory.
Avoiding margin calls
As you cut the neck of your losing trades, these orders can prevent your accounts from reaching point zero. They are widely preferred by day and news traders where exit points ensure that volatile movements in the market don’t turn your portfolio into dust.
Using stop losses and take profits in combination provides a fair amount of information on the risk/reward ratio and the win rate. Having an insight into such features helps determine potential factors, e.g., profit factor, z score, etc. The knowledge may give your trading a boost.
Many novices and even amateurs ignore the term consistency, a big part of which is related to stop losses. A valid exit point in your trade will help you beat the markets day in day out. Such a process, if repeated, can lead to successive gains in the long term.
Keeping a particular exit point in your trade will keep your mind free of any emotional influences as you know that your losses are limited. As psychology constitutes a significant part of trading, having definite control over your mindset is fruitful.
Monitoring the Markets
You don’t need to monitor the markets 24/7 as you predetermine your entry/exit points. One can set and forget with stop losses giving themselves a bit of time for their own well-being and fun.
Are there any disadvantages of stop loss orders?
Considering all the benefits of stop losses, it can be hard to grasp that such order can also possess a downside to their use. The problem lies in the fact that short-term movements in the markets can cause your exit points to trigger, moving you out of a possible win trade. This type of issue is prevalent with scalpers who have their SL close to their entries.
In times of low liquidity or high volatility, limits and stop orders may or may not execute at the desired price. Sometimes it may be difficult for you to determine the exact level where you should place the exit. A wrong spot may result in the market hitting the loss and reversing back to profit, leaving you disturbed.
End of the line
Stop-loss orders must be looked at as an insurance policy in your trading. One of the primary reasons why 90 percent of traders leave the markets in their initial years is improper risk management by not using any exit points. A person should know his or her game plan before entering any trade that consists of his take profit and stop losses. It is a simple tool giving your trading a considerable boost.