Stop loss is a trading tool that allows traders to limit their losses in case the market moves against their positions. A stop loss order is an instruction to close a trade at a certain price level, usually below the entry price for a long position or above the entry price for a short position. A stop loss order is important in trading because it reduces the risk of holding a losing position for too long and prevents emotional decisions that can worsen the situation.
Why have a stop loss
Stop loss orders are very important and they can help traders to:
Protect their capital
By setting a maximum amount of loss that they are willing to accept for each trade, traders can avoid losing more than they can afford and preserve their trading account balance.
Manage their risk
By defining their risk-reward ratio and sticking to it, traders can control their exposure to market volatility and avoid emotional decisions that may lead to overtrading or revenge trading.
Follow their trading plan
By having a clear exit strategy for each trade, traders can execute their trades according to their trading plan and avoid being influenced by fear or greed.
Also see: Some ways of setting up stop loss levels
Types of stop loss orders
There are different types of stop loss orders, such as:
Fixed stop loss
This is the simplest type of stop loss order, where the trader sets a fixed price level to close the trade if the market reaches it. For example, if a trader buys INFY at 1000 and sets a fixed stop loss at 950, the trade will be closed automatically if the price drops to 950 or lower.
Trailing stop loss
This is a dynamic type of stop loss order, where the trader sets a distance from the current market price to close the trade if the market moves against it. For example, if a trader buys ACC at 800 and sets a trailing stop loss of 6%, the trade will be closed automatically if the price drops 6% below the highest price reached since the entry. The trailing stop loss will move up with the price as long as it goes in favor of the trade, locking in profits along the way.
Also see: Trailing Stop Loss indicators in ChartAlert
Guaranteed stop loss – offered by forex brokers
This is a special type of stop loss order, in the forex market, that guarantees to close the trade at the exact price level specified by the trader, regardless of any market gaps or slippage. For example, if a trader buys EUR/USD at 1.1000 and sets a guaranteed stop loss at 1.0950, the trade will be closed at 1.0950 even if the market gaps down to 1.0900 overnight.
Guaranteed stop loss orders usually come with an extra cost or a wider spread
Limitations
Stop loss orders are an essential part of trading, as they can help traders to protect their capital, manage their risk and follow their trading plan. However, they are not foolproof and they have some limitations, such as:
False signals
Sometimes the market may trigger a stop loss order and then reverse in favor of the original position, causing the trader to miss out on potential profits or incur unnecessary losses.
Market gaps
Sometimes the market may gap over a stop loss order due to high volatility or low liquidity, causing the trader to close the trade at a worse price than expected. This can be avoided by using guaranteed stop loss orders, but they may not be available for all instruments or brokers.
Human errors
Sometimes traders may forget to set a stop loss order, set it too tight or too wide, or move it manually against their trading plan, exposing themselves to more risk than intended.
Therefore, traders should use stop loss orders wisely and consistently, and review them regularly to ensure that they are aligned with their trading objectives and market conditions.