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What is a stop loss? A quick guide on how to use stop-loss orders

10:02, 3 June 2022

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What is a stop loss? A quick guide on how to use stop-loss orders. Stock market trading floor concept. Stock tickers, market quotes at blue background and the reflection of thinking trader.
What is a stop loss? A quick guide on how to use stop-loss orders Photo: MaxxiGo / Shutterstock.com

If you can’t sleep at night thinking about your open trades, chances are, you are not taking advantage of a stop loss order.

Taking profits and accepting losses is a natural part of trading. The idea is to keep the losses smaller than the profits. To achieve this, it's essential to cut your losses when needed. A stop loss market order is one way to reach this goal more consistently. 

Whether it's a stop loss in share market trading, a stop loss in FX trading or any other financial market, having a mechanism to automatically exit your trade at a loss amount you predefined takes a big weight off your shoulders and can improve the consistency of your trading.

What are stop losses?

A stop loss is an order placed with a broker to buy or sell a security when it reaches a certain price. A stop loss is designed to limit an investor's loss on a security position.

Stop losses are a type of pending order. That means the order is pending on a certain event, usually a specific price level getting hit. 

For long positions, a stop loss is triggered when the price falls to a specific price level. For short positions, which benefit from falling prices, a stop loss will be triggered when the price rises to a specified price level. 

How do stop losses work?

A stop loss is a form of stop order to sell if you are long or a stop order to buy if you are short. Stop orders work by executing the order at the next available market price after the price specified in the order is hit. For a sell stop, it is the bid price that must be hit, and for a buy stop it is the ask price that must be hit.  

This means that in fast-moving markets, there can be slippage where a trade will be exited at a different price than specified in the order. 

Stop losses are not full-proof. Other risk management techniques should be employed as well to mitigate the risk of unexpected loss.

There are typically two ways to add a stop loss to a trade, before the trade and after the trade.

Below is an order ticket for shares of Tesla (TSLA) on Capital.com platform. When opening a position, you can turn the ‘Close at loss’ slider on, specifying the level you want the position to be closed at. In the example below, a stop loss order is set $24.33 below the current Tesla share price at $744.33.

Tesla ticket order with a stop loss

You can also add a stop loss order after the position has been opened. Here is an example of an open trade in EasyJet shares. From your ‘Portfolio’ on Capital.com, a stop loss order as well as a take profit order can be added afterwards.

adding a stop loss to an open trade

Types of stop loss orders

How to use stop losses, including the type of a stop loss will depend on the kind of trade you are placing.

  • Standard stop

Standard stop losses are the most commonly used. The stop loss order is placed at a fixed price level. 

If you buy a stock and use a standard stop loss, when the price moves in your favour, the stop loss will not move and not get triggered. Equally if the price moves against you, the stop loss will stay fixed at the specified price level and eventually get triggered. 

Note: standard stop losses can be changed before they get triggered but not afterwards because by then the trade is already closed.

  • Trailing stop

A trailing stop loss is a type of stop loss order that is placed at a certain distance from the current market price. 

For example, if you bought a stock for $100 and it is currently trading at $120, you might place a trailing stop loss order of $10. While the price is at $120, the trailing stop loss will be at $110. 

Should the market price rise to $121, the stop loss will ‘trail’ the market price and rise as well to $111. However, should the market fall back again to $120, the trailing stop will remain at $111.

  • Guaranteed stop

A guaranteed stop loss similar to a standard stop loss, except that the price specified in the order is guaranteed to be the exit price of the trade, rather than the next available market price. For this guaranteed price execution, the trader will pay a fee to the broker.

types of stop loss orders

Stop loss vs Take profit order

Stop losses and ‘take profits’ are both a form of pending order to exit a trade. A stop loss order will take you out of the trade at a loss, while a take profit order will close the trade with a profit.

Natural Gas

6.94 Price
-0.580% 1D Chg, %
Long position overnight fee -0.1437%
Short position overnight fee 0.1041%
Overnight fee time 21:00 (UTC)
Spread 0.020

Oil - Crude

79.31 Price
-2.390% 1D Chg, %
Long position overnight fee 0.0226%
Short position overnight fee -0.0420%
Overnight fee time 21:00 (UTC)
Spread 0.03

BTC/USD

19,304.15 Price
+0.150% 1D Chg, %
Long position overnight fee -0.0500%
Short position overnight fee 0.0140%
Overnight fee time 21:00 (UTC)
Spread 60.00

XRP/USD

0.48 Price
-0.010% 1D Chg, %
Long position overnight fee -0.0500%
Short position overnight fee 0.0140%
Overnight fee time 21:00 (UTC)
Spread 0.00600

As mentioned previously, a stop loss is a type of stop order. A take profit is a form of limit order, which is an order to buy or sell a security at a specified price or better. Limit orders are not guaranteed to be executed.

A buy limit order would be used to execute a take profit order on a profitable short position. It can only be executed at the limit price or lower. A sell limit order would be used to take profits on a long position and can only be executed at the limit price or higher. 

Why are stop losses important?

Stop losses are important for managing risk in trading. They are designed to limit the amount of loss that can be incurred on a trade. 

Stop losses are important for a number of specific reasons in risk management. 

  • They help to protect your capital by limiting losses on a trade. 

  • They can help to ensure that you don't exit a trade too early and miss out on potential profits. 

  • They can help to keep you from emotional trading and cognitive biases, which can lead to poor decision-making.

All of these reasons underscore the importance of having a stop loss in place, ideally as part of a risk management plan before you enter a trade. 

How to calculate a stop loss for long and short positions?

Let’s go through the process and simple formulas needed for stop-loss calculations in points as well as currency. Stop loss size equates to points at risk multiplied by position size.

Risk vs reward ratio

When deciding where to place a stop loss, traders typically consider the risk vs reward ratio, – the ratio of the potential loss to the potential gain on a trade. For example, if a trader has a potential loss of $100 and a potential gain of $200, the risk reward ratio would be 1:2.

The risk reward ratio is an important consideration when placing a stop loss because it can help to determine the potential return on investment. If the potential gain is higher than the potential loss, then the trade may be worth taking, and vice versa.

A long position with a stop loss

To calculate a stop loss for long positions, we first calculate points at risk

For example, you buy some shares with a long entry of $10 and a stop loss at $7. The difference between them - in this case $3 - is your points at risk. 

$10 - $7 = $3 at risk

If you bought 20 shares, then your stop loss is 

$3 x 20 = $60

A short position with a stop loss

Now, let’s say you go short 10 shares at $25 and your stop loss is at $31.

$31 - $25 = $6

10 x $6 = $60

Example of a stop loss

In this stop loss example let’s use famous fund manager Cathie Wood’s ARK Innovation ETF (exchange-traded fund). 

In this hypothetical trade, a trader might have decided to short the ARKK ETF at $140 after an uptrend line break following a fast run-up in the price. 

Placing a stop loss above the all-time high at $160 would mean a stop loss of $20. To achieve a 2:1 risk vs reward ratio on the trade, the trader could have set $100 as their profit target with a potential gain of $40.

In this particular example the price reached the take profit order and continued down well past it, but on many occasions a stop loss will get triggered for a losing trade. 

ARK innovation etf stop loss and take profit levels example

Limitations of stop loss orders

Stop loss trading has several potential drawbacks that traders should be aware of. 

  • If the stock price gaps down below the stop price, the order may not be executed at the desired price. One potential way around this limitation is to use a guaranteed stop loss. 

  • Stop loss orders can be triggered by false rumours or technical glitches, leading to an unwanted sale of the security.

Note that all trading contains risk. Always conduct your own due diligence, looking at technical and fundamental analysis, latest news and analysts’ commentary. Keep in mind that markets remain volatile. Past performance does not guarantee future returns. And never trade money you cannot afford to lose. 

FAQs

How to set stop losses

There are a couple of different ways to set a stop loss. The first is to set a percentage stop loss. This means that you will sell the security when it falls by a certain percentage from the price at which you bought it. The second way to set a stop loss is to set a currency amount stop loss. This means that you will sell the security when it falls by a certain amount from the price at which you bought it. You can also set a stop loss as a price level. The stop loss order will be executed when the asset hits the price you have set.

What is a good percentage to set a stop loss?

There is no definitive answer to what is a good percentage to set a stop loss, as the appropriate percentage will vary depending on the individual trader's risk tolerance and trading strategy. Some traders may feel comfortable setting a stop loss at 5% of their account value, while others may choose to set it at 10%. Ultimately, it is up to the trader to decide what percentage is best for them.

What happens if the market opens below a stop loss?

If the market opens below your stop loss on a long position, the position will be automatically closed at the opening level. This would mean a loss of the difference between your entry  price and the opening price. Had you used a guaranteed stop loss, the trade would be closed at your stop price, saving you the difference between the stop loss price and the opening price minus the fee for the guaranteed stop.

Should long-term investors use stop losses?

Stop losses can help protect investors from catastrophic losses in the event of a sharp decline. Stop losses can also trigger selling at inopportune times and cause investors to miss out on potential gains. Ultimately, the decision of whether or not to use stop losses is a personal one that depends on the individual investor's risk tolerance and investment objectives. Keep in mind that markets are volatile. Past performance does not guarantee future returns. And never invest or trade money you cannot afford to lose. 

What You Need to Know

The week ahead update on major market events in your inbox every week. Subscribe
The difference between trading assets and CFDs
The main difference between CFD trading and trading assets, such as commodities and stocks, is that you don’t own the underlying asset when you trade on a CFD.
You can still benefit if the market moves in your favour, or make a loss if it moves against you. However, with traditional trading you enter a contract to exchange the legal ownership of the individual shares or the commodities for money, and you own this until you sell it again.
CFDs are leveraged products, which means that you only need to deposit a percentage of the full value of the CFD trade in order to open a position. But with traditional trading, you buy the assets for the full amount. In the UK, there is no stamp duty on CFD trading, but there is when you buy stocks, for example.
CFDs attract overnight costs to hold the trades (unless you use 1-1 leverage), which makes them more suited to short-term trading opportunities. Stocks and commodities are more normally bought and held for longer. You might also pay a broker commission or fees when buying and selling assets direct and you’d need somewhere to store them safely.
Capital Com is an execution-only service provider. The material provided on this website is for information purposes only and should not be understood as an investment advice. Any opinion that may be provided on this page does not constitute a recommendation by Capital Com or its agents. We do not make any representations or warranty on the accuracy or completeness of the information that is provided on this page. If you rely on the information on this page then you do so entirely on your own risk.

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