To limit your losses when trading, you need to learn what a stop loss is. This type of order can become your best ally to manage the risk of the operation and at the same time analyze the markets with greater peace of mind. Having tools to control the amount of money you can lose will make a difference in your operations. This way you can have more options to be profitable. Read on to find out how stop losses work, the types of orders available to limit your losses, and everything you need to consider, including these tools in your strategy.
What is a stop loss in trading?
The stop loss order is a tool used to set the amount of money you can lose on a trade. This order works automatically when the price of an asset reaches a pre-set level and a buy or sell order is executed.
How does a stop loss work?
In the specific case of buy trades, possibly a long position, the stop loss works as follows: Imagine a context in which the S&P 500 futures contract is worth $10, and you want to open a trade at that price. Therefore, you buy the futures contract at $10 with the objective that if it rises in price to $12 you can sell it and thus earn $2 in profitability. What would happen if instead of the price going up, the price goes down? You would make a loss on your trade. To reduce your losses, you can use a stop loss order and signal a sell order to be triggered if the price goes down to $9, so you would only lose $1. If you don’t do this, the price could go even lower and therefore the loss could be greater. On the other hand, in a sell trade, which could be a short position, it would work as follows: In the same context, now the objective is to sell at a high price and buy back at a cheaper price to gain profitability.
So, you borrow a futures contract and manage to sell it at $10, then wait for the price of the contract to drop to $8 to buy it back again, and by returning the borrowed contract, you would generate $2 in profitability. In this case, to protect yourself, you would set a stop loss order with the objective of triggering a buy order in the event that the contract increases in price to $11, so you could limit your loss to as little as $1. Finally, you should note that depending on the speed at which the price of an asset changes or the volatility of the market itself, the stop loss may be triggered but the order may not be executed at the previously set price.
Types of stop losses
Aside from the traditional stop loss order, traders have access to two other order types to refine their risk management. The stop limit order merges stop loss and limit order features, enabling traders to specify both the trigger and execution prices, reducing the risk of slippage in volatile markets. Meanwhile, the trailing stop order dynamically adjusts the stop loss level in response to favorable price movements, automatically tracking the asset price to lock in profits and protect against losses. These alternative order types empower traders to optimize their risk management strategies and enhance trading performance across diverse market conditions.
Unlocking Precision with Stop Limit Orders
Stop limit orders combine stop loss and limit order functionalities, allowing traders to specify both activation and execution prices precisely. This precision minimizes the impact of market volatility and ensures trades are executed at desired prices or better. By providing clear entry and exit points, stop limit orders empower traders to navigate volatile markets with confidence, optimizing trading strategies while mitigating potential losses.
Trailing Stop
The trailing stop is a dynamic order set at a distance from the asset’s opening price. It adjusts with market movements, moving in favor of the trader’s position. If the market moves against the trader, a limit is set, triggering a market order when the price reaches it. This strategy allows traders to lock in profits while protecting against potential losses, offering flexible risk management in changing market conditions.
Stop Loss vs. Stop Limit: Understanding Order Types
A stop loss order triggers a market order once the stock reaches the target price. However, this does not mean that a buy or sell is assured at that exact price; this varies depending on market conditions and the speed at which the price moves. This means that it will be executed at the next available price. For example, if a stop loss is set at $10, the moment the stock exceeds that price, it will be executed; however, the purchase or sale may be made at a different price, i.e., at the next available price. The stop limit order, on the other hand, is a way of ensuring that the market order is executed only at the price set. In other words, if the stop limit order for a stock is set at $10, the buy or sell will only be executed at $10. Similarly, a stop loss order does not give you the advantage of a possible rally in the price of a stock, as it will be filled at the next available price as soon as it rises above the set price, whereas a stop limit order gives you the ability to lock in the price if the stock rises.
Stop loss strategies
There are different types of stop loss strategies that serve different purposes. That is why we explain the following strategies so that you can consider implementing them according to your trading style.
Understand market volatility
All markets and financial assets move differently. For this reason, having an overview of the volatility of the market you want to trade will help you better determine how much to use in a stop loss.
Consider your framework of analysis
This takes into account variables such as the timing of trades and the number of trades to be made. This is key because it influences how you will use your stop loss when setting the price.
Understand the relationship between risk and reward
In the world of trading, the relationship between these two elements is proportional, meaning that the more you put at risk, the more profit you can make. Therefore, establishing this will be of great help to you in using this type of order.
Why is it important to use a stop loss order?
It is important to use a stop loss order in markets with high volatility, i.e., markets that are considered high risk. This way you can protect your capital from large losses. It should also be noted that when trading there is a risk of losing money. For this reason, it is advisable to invest only the amount you are willing to lose and ensure that your financial health is not compromised. However, proper risk management can help you to minimize the loss of money as much as possible. In the world of trading, it is always better to lose as little money as possible on each trade to keep your capital safe and continue trading in the market.
Conclusion: Mastering Stop Loss Strategies for Safer Trading
In the world of trading, there are different types of stop losses that will serve you according to your financial objectives. Not all market traders have the same level of risk tolerance. Trading will always be an investment risk; therefore, it is up to you as a trader to use tools that help you minimize the risk of losing money as much as possible. Remember, never invest more than you can lose. Also, if you want to better understand how to use a stop loss, you can use a simulator for practice. It will help you test your pricing skill and understand more accurately how much money you can avoid losing with this tool.
