Trading and stop loss
Among the ‘tools’ that investors and traders cannot do without, the Stop Loss Order is perhaps the most important.
We have already dedicated an article to the different types of orders in trading, offering a general overview. In any case, given the delicacy of the topic, here is a further deepening focused on the stop loss.
The concept is simple to understand and equally easy to use. The real pitfall lies in choosing the right placement of the stop-loss, so as to avoid excessive losses or missed gains.
It really does take five minutes on the clock to read the following. At the end we will be more aware and will be able to set the stop loss in our trades more efficiently.
Happy reading!
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What is a stop loss order?
The stop loss is always on our minds. What is it?
The stop loss (sometimes spelled with a hyphen) is a type of trading order that can also be used by normal investors. It protects us from market movements contrary to our expectations and technical analysis, and prevents us from incurring serious losses.
It has happened (and will happen again) to everyone. You expect bitcoin, gold or a stock to go in one direction; consequently, you set up a trading position; after which the market decides to go the other way.
In such cases, it is often tempting to wait for a possible reversal that meets the forecast. Unfortunately, this sometimes does not happen and further losses result.
Both traders and investors have to accept that one cannot always be right: losses are a normal occurrence in every sector, not only in crypto.
Of course, an investor in the long term can more freely ignore variations in the short term. Here too, however, it should be pointed out how things can take a turn for the worse.
Simply put, capital must be protected. Clearly, those who operate in the short term, especially when trading, will have to be much more careful and rigorous than those who reason on extended time frames.
The stop loss is an order that is set when the position is opened. It is not active until the indicated threshold is reached, at which point it comes into play, closes the trade and limits losses.
The idea behind the stop-loss is simple: when setting a position, one should consider supports, resistances and other useful data to analyse the scenario. The moment the analysis is invalidated, all that remains is to close everything down.
If taken into account and calculated, a loss is part of the game. This type of order is here to help.
The stop loss can be either a buy or a sell. The terminology distinguishes it into Stop Sell and Stop Buy. We may still find variations, depending on the broker.
The stop sell comes into play when opening a long position on an asset. Conversely, the stop buy is used in short trading (known as short selling).
Let’s look at a couple of brief examples to fully understand what has just been explained.
"Whether selling or buying, never give up capital protection"
How is the stop loss set up? Examples
Let’s start with the stop-loss type stop sell .
Let us imagine that we want to buy Nio shares, a well-known company that produces electric cars. Our analysis suggests that the market will reward this stock and so we say to ourselves ‘why not take advantage of it?’.
When buying we place a stop just below a solid support, so as to protect the capital. To give some numbers, let’s say the stop loss is placed at -5% relative to the load price. Please note: we are making a random example, we do not take this number as a reference.
In the days that followed, what we had assumed turned out to be wrong: with the help of unexpected news, Nio’s shares recorded serial losses. At some point, support gives way and shortly afterwards our stop loss is triggered and the position is closed.
What can we say?
First of all, the news invalidated our analysis. This alone would be enough to close the position, because it would be set on something that no longer makes sense.
Secondly, the stop loss protected us, causing us to take a loss limited to 5% of our capital. Without it, if Nio shares had fallen further, the damage would have been greater.
You may think ‘well, maybe then the stock will recover and you will also avoid the 5% loss’. Of course, but the crystal ball is a myth and we cannot have any certainty. Only analysis should guide us; when it is wrong, the position should be closed without hesitation.
This was just an example, applicable to any asset: Unicredit shares, bitcoin, gold and so on.
Let us move on to the stop buy, the exact opposite.
Our research leads us to believe that Unicredit shares will fall in price. The decision is made: we will implement a short sale, so as to gain even from a bearish phase.
Unfortunately, we have not been very good or accurate: the market is all green and Unicredit shares are no different.
However, we are not reckless: our stop buy is there precisely because of this. Having reached the set threshold, the order will buy the Unicredit shares needed to close the position.
The loss taken will be limited to the difference between the short sale price and the purchase price of the asset (higher, contrary to our expectations).
The same considerations as above apply: perhaps the next day Unicredit shares will return to the direction originally assumed. We cannot know this and it would be pure gambling to remain positioned.
"Stop Sell and Stop Buy: two opposite orders that protect us from possible serious losses"
Why is the stop loss so important?
The stop loss is not just a tool that automatically closes a position. In fact, it is a fundamental element at the strategic level.
Anyone involved in trading knows how important risk management is. You determine your allocations upstream, how much you are willing to lose per trade, how much you should gain, and much more.
The stop loss is therefore not something to be set by feel, just for the sake of it. It is part of the equipment needed to stick to the strategy decided at the table: without it we would be going against our own decisions.
The role of the stop loss is also a bit of a ‘psychologist’.
When open positions go wrong, the temptation is to stay there, hoping for sudden reversals that bring sunshine back into a stormy day. Emotions and feelings come into play that make us irrational, the worst situation for trading the markets successfully.
Well, the stop loss doesn’t care what goes through our heads. It is there, ready to nip our doubts in the bud, covering our backs and safeguarding our capital.
The stop loss is not set randomly: technical analysis will lead us to choose the right levels; the rationality of the moment can be exercised regardless of the emotionality of the present. A huge advantage for being a winner over time.
Moral of the article: always set a stop loss, even if you are an investor. We can only make exceptions for assets we wish to hold for a long time, again with reservations and due reasoning.
Once set, NEVER remove it without reason. New analyses or mistakes must support this action, otherwise let us neither change it nor touch it.
What is the difference between a limit order and a stop loss order?
What is the difference between a Stop Loss Order and a Limit Order? Let’s find out now.
We understand that the stop loss protects us from losses, including trading short positions. It is a market order.
The Stop Limit is part of both the Stop Loss family and the Limit order family. It is in fact a limit order that is triggered the moment the selected Stop Loss is reached. The danger of this type of order lies in the uncertainty; in fact, under certain conditions it may not be executed. It is up to the trader to assess whether the Stop Limit is right for him, or whether to opt for a simple Stop-Loss instead.
How best to set a stop loss?
How to set a stop loss? Question to which it is difficult to give a clear and concise answer.
As a general rule, the stop-loss should be inserted near key levels such as supports, resistances, possible crossings of moving averages and so on. It is therefore difficult to establish universal indications, precisely because indicators and thresholds that can be combined come into play.
Just to give you an idea, the analyst usually looks for levels and crosses various data with each other. He then sets the protection by giving it more or less breathing space; for example, with support at $1000, a stop loss could be set at $980, $970 or $950. There is no wrong figure: it is all based on the trader’s considerations, stop loss distribution, volatility, risk…
In light of the facts, the study is the answer to the opening question.
Let us learn to read the charts and listen to the information they provide. Then let’s practise and keep everything plotted so we can assess our decision-making skills on the stoploss. It can become a game, it is great fun as long as there is no capital involved: try it, it will be a challenge!
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