Stop-loss orders can act as a free insurance policy, helping you to limit downside risk from trading strategies.
Essentially, a stop loss is a pending order that is activated once a given asset´s price moves to a certain level.
This could be a downward move in price in the case when you have entered a long position to benefit from price appreciation.
Or, in the case where you are shorting the asset to profit from falls in the price, the stop loss could be triggered when the price rises to a certain level.
In the extreme, a stop-loss order could prevent you from losing all your accumulated trading profits in one go should a trade move against you.
Firstly, it´s essential to remember that stop-loss orders are based on the bid and ask prices of the asset.
Suppose you enter a long position on the FTSE 100 index using a CFD because you think the UK stock market will rise on a certain day.
As a simple example, if you are buying at 7115 and you want a stop-loss order at around 1% below that, you would choose 7044 as the level at which your stop-loss order will be triggered.
If you´re using a stop loss to cover a short position, for instance when you are using a CFD to profit from a downward movement in the stock market, you might decide to set a stop loss at 1% above 7115, so at 7186 points.
As soon as the price reached your stop-loss level the action would be triggered. In a long position, the stop-loss order would sell. In a short position the stop-loss order would buy.
In the case of our long position, imagine the trade moves our way and the FTSE 100 price rises 1.5%, from 7115 to 7222 points.
Assuming you are using five CFDs, each with exposure of £1 per point, your profit if you choose to close the position would be: (7222 – 7115) x 5 = £535.
However, suppose the stock market instead falls on that day, and your stop loss is triggered at the lower price of 7044.
Your loss from the long CFD trade on the FTSE 100 index would be: (7115 – 7044) x 5 = £355.
The benefit of a simple stop-loss order in managing risk can be more fully appreciated if you consider what would have occurred on the same day had we not had the stop loss in place.
Imagine the stock market had fallen considerably further than the 1% price level we set.
Assuming the index had fallen about 2% on that day to 6973 points, and we´d closed our long position at that level, our loss would be: (7115 – 6973) x 5 = £710.
In the event, we could have chosen to close the position around the 1% level ourselves without the stop loss, or even earlier.
But without the discipline that a stop-loss order imposes, too many of us tend to hold on in the hope that an adverse price movement will quickly reverse itself and the market start to move in our favour.
In reality you need to take into account the difference between the bid price, or sell price as it is also known, and the ask price, sometimes called the buy price. The difference between the two is called the bid-ask spread. The more volatile the asset, the wider the spread.
In this case, the bid price might be at 7114, while the ask price might be just 7115.
If you decide to set a stop loss at around 1% below the ask price of 7115, you would choose 7044 as the level at which your stop-loss order will be triggered. Your stop-loss order will be triggered when the bid price hits your stop-loss order price.
If you´re using a stop loss to cover a short position and you set a stop loss at 1% above the bid price of 7114, so at 7185 points, the order is triggered when the ask price matches your stop-loss order price.
Note: your stop-loss order must always be outside the bid-ask spread, otherwise it would be immediately activated.
Stop-loss orders can be used to get more out of technical trading strategies.
For instance, traders can combine a stop-loss order with a technical trading strategy, drawing on both volume-weighted average price (VWAP) and Bollinger bands.
Someone taking a bullish stance may look for a VWAP cross as a sign of momentum when other buyers are entering long positions. This is when the current price crosses over the volume-weighted average, with traders often looking to buy at a VWAP cross price lower than the VWAP.
In the case of an asset that is on the rise, the same trader may choose to implement a stop loss at a previous time frame´s upper VWAP cross.
Bollinger bands are graph lines plotted two standard deviations away from the moving average - above and below the average - and are a measure of volatility. For a rising asset, a trader might put a stop loss at the lower end of the Bollinger band.
Conversely, someone taking a bearish position on a given asset to profit from price falls may choose to implement a stop loss at the upper end of a Bollinger band.
For an asset that has been falling in price, they could also set up a stop loss at a previous time frame´s lower VWAP cross.
A trailing stop-loss order can provide investors with greater flexibility compared with traditional stop orders.
Trailing stops will automatically adjust to take into account the current market price of the stock.
Taking the example of the investor who had a long position on the FTSE 100 index using five CFDs when the sell price was 7114 and the buy price was 7115, you will recall that we previously set a standard stop loss to cover a 1% price fall.
In the event of a trailing stop loss set at the same level, the sell order would still be triggered if the price fell by around 1% to 7044 points.
However, if the buy price were to move up, say to 7222 points, the broker would move the stop-loss order up to about 7150 points.
Therefore, if the price was to subsequently fall from 1% after reaching 7222, the position would be closed out at 7150.
Nevertheless, since the long position was entered at 7115, the long CFD position would still be in profit:
(7150 – 7115) x 5 = £175
In this sense, trailing stop-loss orders can be more dynamic, adapting automatically in an evolving market, while giving the investor the same level of downside protection as they sought at the onset of the trade.
When the market is especially volatile, trailing stop-loss orders can be more useful in helping investors to lock in profits.
However, the major problem with stop-loss orders is that execution is far from guaranteed. In other words, the stop loss is only as good as when others happen to be in the market to take the opposite end of the trade at that price, either as a buyer or a seller.
With something like the FTSE 100 or even bitcoin, this isn´t normally an issue as these markets are highly liquid. If, however there is not a buyer and seller available at a given price then no trades are made at that price, causing a price gap.
Price gapping can occur around major events that cause very sudden movements in the market.
There´s also a much higher likelihood of a price gap if you choose to keep a position on the likes of the FTSE 100 open overnight, when the stock market is closed.
No free lunch
In this case, if your stop loss falls in a price gap, you could find that it gets transacted at a much less favourable level than you had originally intended.
To avoid this problem, you can choose to take out what´s known as a guaranteed stop-loss order (GSLO).
As the name suggests, a GSLO means your stop loss is guaranteed to be triggered at the level you intended.
However, to take out a GSLO you also have to pay a premium for the privilege. This is quite unlike the standard stop-loss order that is generally viewed as a free insurance policy.
Clearly, using a stop loss can help you to better control the risks you are taking.
It can also allow you to target a given risk reward ratio, so you enter a trade with some tangible profit objective that takes account of underlying risk.
Many investors like to enter trades that allow them to at least theoretically double their money.
CFDs potentially allow investors to do far better as they require you to only put down a margin rather than the whole amount of the position.
Nevertheless, the risk reward ratio is a simple way of helping us set buy or sell orders on assets.
As an example, suppose a CFD provider is quoting bitcoin at an ask (buy) price of $8,236 and a bid (sell) price of $8,118. The bigger spread compared with the earlier example of the FTSE 100 is indicative of bitcoin´s higher volatility. And remember: your stop-loss order needs to be outside that bid-ask spread.
As you anticipate the price of bitcoin to fall, you sell 10 CFDs at the quoted price of $8,118.
You set a stop-loss order at 2% above the entry bid price, choosing the $8,280 price level.
Suppose the trade moves in your favour and the ask price falls 10% to $7,412.
You make a profit on the 10 CFDs of 10 x ($8,118-$7,412) = $7,060.
On the downside, however, suppose that instead the market moves in the other direction and the ask price rises to $8,280.
You would lose 10 x ($8,280-$8,118) = $1,620.
If we set orders to close the position when we are in profit at a sell price of $7,412 and a stop-loss order at $8,280, our risk reward ratio is:
$7,060/$1,620 = 4.3:1
As a general rule, 2:1 is considered the minimum risk reward pay off by most investors, though some will not commit to an investment below 4:1.
While 4.3:1 sounds healthy, we may increase our probability of success by making our objective more conservative.
In this example, one way to do this is to close out the position earlier when we are in profit, perhaps when the price is at $7,750. That would reduce the risk reward to around 2.3:1.
For many traders, the level at which to set the stop loss is frequently a dilemma. Err too much on the side of caution, setting the stop loss excessively near to the point at which you entered the trade, and you could find that your positions are too frequently closed out early.
Asset prices do not move in a straight line, and instead see numerous ups and downs over the trading day.
You therefore need to be able to give some leeway for your position to trade in the red before it moves into the profit zone.
Once in the profit zone, you also need to make sure you are closing out the position at a point where you are making a worthwhile gain.
Another consideration is that volatility varies greatly between different assets.
When trading a cryptocurrency, you´re likely to need to set stop losses at a much greater percentage distance away from the trade initiation price level than if you´re trading a more established asset such as the FTSE 100.
Using technical references, such as Bollinger bands or VWAP crosses, should help you adjust the stop-loss level more appropriately given the specific volatility of the given asset.
Calculating your risk reward objective and setting your profit and loss price limits can also help ensure your trades make economic sense as well as enabling you to better control risk.