What is a stop loss and how to use it?

When using any type of trading exchange like FOREX, or stocks and shares, you can execute different types of orders. An order is essentially a set process involving the buying and/or selling of an item on the exchange with set parameters. One of the most common types is the stop loss order. In this guide, we explain what a stop-loss order is, its pros and cons, and how to use it for trading.

Stop loss order – a method to limit your potential losses

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Stop Loss Order = An order placed with an exchange/broker to sell a specific item (stock/currency etc.) once it reaches a set price.

Confused?

Let’s give an example.

You buy shares in Apple at $10 per share. After buying shares, you create a stop loss order at $9. Therefore, if the stock prices drop to $9, your order is triggered, and your shares are sold for $9 each.

As you can see, this type of order enables you to minimize losses during market slumps. It also allows you to lock profits as explained below.

Advantages and disadvantages of stop loss orders

Now that we have given an example of a stop loss order, we can delve into its pros and cons.

Advantages

Stop loss orders can be hugely beneficial when used correctly. They offer the following benefits:

  • Can be viewed as a free insurance policy
  • Less monitoring of price fluctuations
  • Removes the “emotional” aspect of trading

Firstly, a stop loss order is a de-facto insurance policy. It doesn’t cost anything to place a stop loss order and commission is only deducted when the order is triggered. Many traders, therefore, use this type of order to simply minimize their losses and have a safeguard against huge, unexpected price drops.

Secondly, using stop loss orders means you do not have to continually monitor prices. Trading can be a drain and intense, therefore anything you can use to limit your work is a bonus.

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Lastly, using stop loss orders helps reduce the emotional aspect of trading. Oftentimes we can get attached to a specific asset – this can negatively impact our decision-making process. Stop loss orders help remove the emotional aspect and make trading purely automated and mechanical.

Disadvantages

Although they have many benefits, there are drawbacks to consider too including:

  • Short-term price fluctuations could trigger the stop loss
  • Trades can sometimes not execute
  • Once the price is triggered, the market price may already be different

The main downfall of stop loss orders is when used on assets that have rapid price fluctuations. For example, it would not be a good idea to set a stop loss order of 5% below the market price, for an asset that regularly moves up or down by 5%. Ultimately, you would end up simply paying a commission and continually losing money.

Secondly, there is no guarantee that the trade will execute. The stop-loss order is simply executing a trade – someone still has to buy that trade and there is no guarantee that your order will be matched. In fast-moving markets, stop loss orders could sometimes fail to process as a result. Your stop loss order could trigger, and the market price could have already changed thus meaning you could end up stuck in an unfavorable position.

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How to use stop loss orders

Stop loss orders are used in two primary ways. Firstly, to reduce potential losses as the name implies. Secondly, to lock in profits when used as a trailing stop.

Loss reduction

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Traditionally, people place stop loss orders to do exactly as the name suggests – to stop losses. By losses, we mean exponentially greater losses. For example, by setting a stop loss order at 10% below the market price you are negating potentially greater losses if the prices fall to 15% or 20% lower, for example. It’s a de-facto insurance policy.

Trailing stop

You can also use stop loss orders to make consistent profit safely. This is known as the trailing stop. You can set a stop loss order as a percentage below the market price – not the price you bought at. 

As the market price changes, so does your stop loss order. This can lead to making consistent capital gains without the need to continually monitor price fluctuations.

Conclusion

We hope you have found this guide on stop loss orders useful. As you can see, the stop loss order is a useful tool to have at your disposal. It can help reduce potential losses from price slumps, but it can also help lead to consistent profits when used as a trailing stop loss.

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