What is a Stop-Loss Order?
A stop-loss order is exactly what it sounds like, an order used to limit or stop losses. In a stop-loss order, a trader enters a position, but subsequently places an order to exit that position at a specific loss point. For example, let’s say you buy Asset A at $25 and place a stop-loss order at $20. If Asset A drops to $20, your position will be sold off at the best market price available. This strategy limits your loss in case the asset continues to tumble.
How Does a Stop-Loss Order Work?
A stop-loss order works within the idea that a trader wishes to limit their potential loss. A trader might decide to execute a stop-loss order in a trader with an asset they seem particularly risky. Most experienced traders recommend incorporating some sort of risk management into your trading strategy and a stop-loss order is a great way to do that. Generally speaking, you want to place a stop-loss order at about 10% less than the average market price you purchased the asset or contract at. This 10% allows for some volatility in case the price drops a little, but protects you against a major drop. However, everybody should a stop level they are comfortable with.
How Do I Place a Stop-Loss Order?
The option to place a stop-loss order is generally offered on most trading platforms on the same screen the trader is executing the trade. Stop-loss orders are a good thing to become accustomed to and can be modified at any time. If you have questions or wish to place at stop-loss order, please contacts one of our Senior Market Strategists and they will gladly assist you.
Stop-Loss Order Example
For example, let’s say Mike purchases a crude oil contract at $60 dollars. Being a smart trader, Mike wants to protect himself against catastrophic losses so when he buys the crude contract at $60 he also places a stop-loss order at $50. Over the next few weeks, crude oil starts dropping and eventually hits $40 dollars. Normally, this would be a huge loss for Mike, but because he put in a stop-loss order at $50, his contract was sold off at market price as soon as the contract his below $50, thus mitigating his potential loss.
Which Stop-Loss Order is Best?
As all traders would agree, nobody ever wants to have to use their stop-loss orders. You want every trade to be a good trade, but unfortunately that is not a plausible reality and the stop-loss order is here to protect you. There are a few different variations of stop-loss orders and it’s easy to find one that best suits you.
Market Orders
Market orders are the simplest and easiest ways to get it or out of a trade. A market order is simply executing a trade at the current market price. There are no predetermined values or levels, it’s an instant buy or sell and the order is executed at the best available price, or market value.
While market orders are simple and relatively instant, there is some downside as slippage can occur, and when time is crucial you could see a larger loss in value.
Stop-Limit
A stop-limit order is more precise and defined type of stop order. In a stop-limit order the underlying asset rests at market price until and order is filled at a price predetermined by the traders. If that price is never hit, the order will not fill.
This strategy is best used when dealing with high volume trading where every penny matters. This is a very precise order and the trader has really be in tune with the market. The downfall to this strategy is that in times of high volatility the order may not be filled leaving the trader with an open position.
Stop Market
A stop market order is the best of both worlds as it combines both the stop-limit and the market order. In a stop market order, the trader determines a price below what they paid for the underlying asset. If the asset falls to that predetermined limit, a market order is automatically executed and the asset it sold of at current market price.
A stop market order is best used in highly volatile markets as it gives the trader a defined basement. They know what their potential loss will be, and when they will be getting out of the trade. On the flipside, there is a possibility of slippage which could create larger losses.
Trailing Stops
And finally, the most advanced stop-loss strategy, the trailing stop. The trailing stop order combines aspects of all the other strategies listed above into one. A trailing stop follows price movement upwards. Let’s say a trader buys a contract at $50 and sets a trailing stop at $45, but then the market price goes up. The trailing stop follows the market price up in a tick by tick fashion. Say the market price rises $1.25 to $51.25, then the stop price would also rice $1.25 to $46.25. However, is the market price then falls back down, the stop price does not trail it back down. A market order would be executed and filled at the best possible price once the asset hit $46.25.
Trailing stops are best used when a trader wants to let a trade run for a while, but also lock in profits along the way. They are best used when trading with the trend.
Benefits of Stop-Loss Orders
There are a lot of benefits to stop-loss order because in their essence they are built to mitigate loss, but perhaps the most important one is that is costs nothing. There is no cost the protect yourself, the only cost is the commission fees your broker charges for executing a trade. It is free insurance against a bad trade.
Another huge benefit to stop-loss orders is they limit the influence human emotion has on trading. It is easy to get attached to trades for one reason or another, and because of that attachment you may be willing to give a longer leash to trades whether they deserve it or not. When you have a stop-loss order in place it takes out that human aspect. You are the one making the decision anymore, the trade is automatically executed at the price you specified which may save you from bigger losses.
Finally, a great benefit to stop-loss orders is they can help you lock in profits. If you buy a contract at market price and the value of the contract rises, you can use a stop-loss to lock in profits. Let’s say you bought a contract at $55 and then a week later it hits $65. You could set a stop-loss order at $60, so if the assets dips back down below $60, you will selloff your position while still maintaining some profits.
How to Determine Where to Set a Stop-Loss Order
Where to set a stop-loss order is not a concrete thing, it is a very situationally based strategy. You want to set your stop-loss order within a risk threshold that you feel comfortable with. This may be larger for some and smaller for others. You do however want to allow room for some volatility, you cannot take that completely out of the equation. The best way to determine your stop-loss order is to talk with your Senior Market Strategist. They are there to help you and can help you define your best options and risk levels.