What is a stop-loss order?
A stop-loss order is an order that a trader places with a broker, instructing the broker to close out any trading positions if the market price reaches a predetermined price, which may indicate a profit or loss.
Put differently, a stop-loss order, commonly referred to as a stop-loss, refers to an order by a trader to a broker, instructing the broker to cancel or reduce the effect (offset) of any loss on a trading position in a given asset, such as a security, commodity, or currency, once a specified price level is reached.
The predetermined or specified price is called the spot price.
One of two types of stop orders
A stop-loss order is one of two types of stop orders, the other type being a stop-entry order.
Stop-entry orders are used to open a trading position when a market reaches a predefined price level. They are usually used to enable traders to take advantage of opportunities in financial markets while they cannot constantly monitor the markets.
Types of stop-loss orders
There are a variety of stop-loss orders, namely a basic or regular stop-loss, comprising a buy stop-loss order and a sell stop-loss order, a trailing stop-loss, and a guaranteed stop-loss order (GSLO).
Buy stop-loss order
A buy stop-loss order is used when a trader opens a short position and expects the price of the financial instrument to drop.
A buy stop-loss is set up as a stop price above the current market price.
Sell stop-loss order
A sell stop-loss order is used when a trader has a long position, meaning the given asset is being purchased with the anticipation that its price will rise.
Hence, the trader benefits when the asset’s price increases. A sell stop-loss order is set up below the current market price.
Trailing stop-loss
The object of a trailing stop-loss is to follow, or ‘trail,’ the price of an asset as it fluctuates (going up and down).
It is a type of order that enables traders to specify a maximum amount or percentage of loss they can incur on a trade. The trailing stop-loss is set a certain number of points, or a specific percentage away from the market price, in order to allow for the fluctuation in the given asset’s price, as the trailing stop-loss adjusts.
If the asset price increases or drops in a trader’s favour, the stop price moves accordingly. If the price of the asset rises or decreases against the trader, the stop remains in place.
Express differently, the aim of a trailing stop is to secure a profit by moving in the direction of a profitable trade, while establishing a limit in case the trade does not move in a trader’s favour.
Guaranteed stop-loss order (GSLO)
A guaranteed stop-loss is a type of order that ensures (guarantees) a trader’s trading position is always closed at his or her predetermined price (the stop price).
It is a common and robust risk management tool, typically used by traders to protect their trades from unforeseen and unnecessary losses during market volatility.
Usually, there is a premium payable on a GSLO, which is based on the current market price of a financial instrument. If the GLSO is not activated, the premium is refunded in full.
Furthermore, the GLSO can be cancelled or changed to a regular stop-loss order, or trailing stop-loss, at any time.
Understanding a stop-loss trading strategy
Stop-loss orders can be used, inter alia, in a highly liquid market such as the forex market, as well as volatile markets, such as stock exchanges, where the markets experience big price swings in either direction.
The decision to set a stop-loss order, and where to set it, depends on a variety of factors, such as:
- The degree of fluctuation and volatility in a particular financial market.
- The historical price movements of the financial instrument and its financial market.
- The type of trader who decides to apply a stop-loss trading strategy. For instance, a longer-term trader may choose a higher percentage distance away from the market price. Conversely, a day trader may decide to set a stop-loss a smaller distance away.
Traders place stop-loss orders in order to protect their profits. However, stop losses should not be placed haphazardly. The best possible place to set a stop-loss is to allow for fluctuation but also allow a trader to exit a trading position if the price goes in an unfavourable direction.
When the price of the financial instrument traded drops below the stop price, the stop-loss order becomes a market order, and it is filled at the next available price.
Where to set a stop-loss order when buying
An uncomplicated method for setting a stop-loss order when buying an asset is to place it below a swing low, which occurs when the price makes a low, immediately followed by two consecutive higher lows.
This is an indication that price found support at that level. When a trader wants to trade in the direction of the trend, the swing lows should be moving up as he or she buys.
Where to place a stop-loss order when short-selling
Contrarily to buying a given asset, a stop-loss is set just above s swing high when selling short. A swing high refers to a situation when the price makes a high and is followed by two consecutive lower highs.
A swing high meets resistance at an upper price level. As with buying, when a trader intends to trade in the direction of the trend, the swing highs should be moving down.
When does a stop-loss order end?
A stop-loss order lasts until one of the following situations occurs:
- The stop-loss level is reached.
- The stop-loss is removed without closing the trading position.
- The trade is closed.
- The stop-loss is cancelled.
Pros of stop-loss orders
- Stop-loss orders allow traders to remain neutral when trading, without the risk of emotional influences.
- Traders are not required to manage trading positions by constantly monitoring the markets.
Cons of stop-loss orders
- There is no guaranteed execution. If the price of an asset drops below the stop price, the stop-loss would trigger, and the asset would be sold at the next available market price, which could be sharply below the stop-loss level.
- If the price movement of an asset is only temporary, a trader may miss a potential profit.
This article does not intend to provide investment or trading advice. Its aim is only informative.
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