In certain situations where a trader is for whatever reason not able to monitor a trade, a stop-loss acts as a safety net. It’s an automatic order that is used to limit the risk of an investment and that will automatically sell your security at a predetermined price point. But why and how should you use stop-loss? Let us tell you.
What is a Stop-Loss?
A stop-loss is an automatic order that can be placed on any trade and that limits your losses. When you place a stop-loss, you tell the broker you’re using that you want to sell your security or underlying asset when that asset reaches a certain price point. Often times, stop-losses are used by a trader that goes on vacation or to a place where they can’t keep an eye on their investments, or when they have a feeling that the price of a security is about to plummet. Day traders also tend to use stop-loss when they have several open positions at once and want to limit the risk of losing money.
Let us use an example to describe how it works.
You’ve bought 1,000 stocks in a company for $60 per stock. Since your initial investment, the stock price has increased to $75, and even though the stock might still increase further, you want to protect your profit. Because of this, you decide to put a stop-loss at $65. That means that if the stock price falls to $65, the broker will automatically sell your stocks.
Stop-Loss for Short Trading
Traditionally, stop-loss has been used for long positions where your goal is to buy low and sell high, which is the most common way of investing. However, lately, stop-losses have become increasingly more popular within short trading. When you use a stop-loss for a short trade, or when betting against the market, the basic concept is the same for a long trade. The only difference is that you put a limit to when the broker should buy the asset instead of selling it.
The Limitations of A Stop-Loss
There is one major issue with a stop-loss, and it’s connected to quick price falls known as gaps. In situations where the price of an asset falls so quickly that the stop-loss isn’t activated, a trader might end up losing more money than expected. For example, let’s say the stock in the example above falls to $70 in a day. Then the company publishes a quarterly report showing that they’ve performed worse than expected and the stock keeps falling in after hours. When the market opens the day after, the stock has fallen to $60 and the stop-loss is activated, but it’s activated at 5 dollars below what you had expected. Gapping is a common problem but in some cases, it can be avoided using a stop-limit order instead.
Stop-Loss or Stop-Limit?
A stop-limit order is very similar to a stop-loss, but there are a few differences that you should know about since they can be used for different situations. As mentioned, a stop-loss is activated at or under a certain price point meaning you can put the stop-loss at $65 but if the price falls to $60 before the stop-loss is activated, your asset will sell for $5 less than you expected.
When you use a stop-limit instead, you need to determine two prices: one stop-loss price and one limit price. The limit price is a price that stipulates when the stop-loss should not be activated so that you can wait for the price to climb back up to the stop-loss price again. To avoid the above-mentioned asset to sell for $60 you can put the stop-loss for $65 and the stop-limit for $63. This means that the security will be sold if the price reaches $65 or $64, however, if the price falls below $63 the stop-loss won’t be activated until the prices climb back to $65 again.
Most investors deactivate their stop-loss orders when their stop-limits have been activated in order to wait for the security to become profitable again.
Guaranteed Stop Loss Order (GSLO)
Another way to protect yourself against gapping and high volatility on the financial markets is by using guaranteed stop loss orders (GSLO). The main difference between a GSLO and a regular stop-loss is that the GSLO guarantees that your security will be sold for the price you determined. In order to place a guaranteed stop-loss order, you have to pay a GSLO premium which in some cases can be quite high. Because of this, GSLOs aren’t always the best option.
How to Best Use Stop-Loss
You should definitely consider using stop-losses since it can help you avoid losses and guarantee profits. But how do you best use a stop-loss? In our opinion, there are two scenarios where you should use this technique.
- If a security that you’ve invested in is already profitable, it’s a good idea to apply a stop-loss to make sure that it doesn’t fall below your profit limit. This is the most common use of a stop-loss and it helps investors guarantee a profit. You are allowed to change your stop-loss price if the security keeps growing.
- You can also place a stop-loss if you have invested in a security and for some reason you won’t be around to monitor it. Maybe you’re going away on a weekend trip and want to leave your electronics at home. Or you’ve placed a two hour CFD trade and have to go to a one-hour meeting.
Stop-Loss and Leverage
The use of stop-loss and stop-limits is extra important when you trading using leverage since the leverage increases the potential risks of loss. In fact, stop-loss strategies are something that most CFD traders use since all of their trades are leveraged and they always want to limit the potential risk as well as lock in profits.
Situations When You Don’t Need Stop-Loss
You should also to remember that stop-losses aren’t something you need to use all the time, especially not since some brokers take out an extra fee for stop-loss orders. Essentially, a stop-loss should be used if you’re not around to sell the security yourself or if there is a significant risk of the security falling in value. In situations where you can keep a close eye on your investments, you don’t need to use a stop-loss.
A buy-stop order is kind of like a stop-loss but in reverse. Instead of deciding when you sell a security, you set a price limit for when to buy a security. Let’s say you have your eyes on a company stock and you have done a technical analysis on it that shows that if the stock reaches a certain price, it’s bound for a bull run. In order to not miss out on the bull run, you place a buy-stop order.
If the stock is currently selling for $20 and your analysis says that if it reaches $23 it’s bound to make it up to $35, you put your buy-stop for $23. This type of trading goes against the typical idea to ‘buy low, sell high,’ instead it’s based on the idea of ‘buy high, sell higher.’
Stop-loss is an automatic order that’s used to limit losses and protect profits. This tool is used when you don’t want the pressure of monitoring all your open positions all the time or if you are going to be unavailable for a certain period of time. There are several different kinds of stop-losses and as an investor, you should have an understanding of how they work so that you can apply them correctly when needed.