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What is a Stop Loss Order and Why You Should Use It

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Successful traders are strategic traders and that means creating a trading plan and having the discipline to follow it. Your plan sets out the instruments you will trade, and your entry and exit points and includes risk management. One of the fundamental elements of managing risk is the use of “stop loss” orders. These elements should be defined in your trading plan. Let’s take a look at what is a stop loss order and why it is essential to your trading success.

 

 

Kips explains: What is Stop Loss?

 

A stop loss (SL) order is a risk management tool you can use when trading to limit your losses if the price moves in the opposite direction than you had anticipated. In short, a stop-loss order enables you to automatically stop a losing position at a predetermined price. In other words, with stop loss, you can set a specific price point or a maximum loss amount at which you wish your position to be automatically closed, should the market move against you.

 

How to Use Stop Loss

 

Stop loss orders can be especially beneficial in the event of a substantial price movement against your trades. In a long position, where you are buying an instrument, you would set a stop loss below the instrument’s current market price. In a short position, where you are selling an instrument, you would set a stop loss above the instrument’s current price.
For example, you might consider buying shares of SPP.JO after reading their latest published earnings reports and think that the company has great potential to grow in the near term. Let’s assume that the SPP.JO share is trading at 50 rands per share. You buy 80 shares at 50 rands per share placing 4000 rands on the trade because you believe its price is about to move up towards 80 rands per share. Hence, if you are not willing to lose more than 800 rands of your initial balance on the trade, you would pre-emptively set a stop loss sell order, just in case the price moves in the opposite direction.
The SL order can be set at 40 rands per share, which will effectively limit your risk to a maximum loss of 10 rands per share, or exactly 800 rands loss on your entire position. This means that if the share price falls to or below 40 rands per share, then your SL order will be automatically triggered, closing out your trade.

 

Why Use Stop Loss

 

As noted above, a stop loss order can help you limit your risk exposure and act as a safety mechanism. This is to protect your account from losses beyond your risk tolerance. Stop loss limits can keep you from falling victim to your emotions and letting your losses run indefinitely in the hopes of a reversal.
The financial markets frequently experience volatility, and it’s recommended that you keep your trading moderated with stop loss. In a rapidly moving market, a stop loss order might not be filled at your exact specified stop price level but will usually be filled at the very close/next available price. The difference between your expected stop loss closing price and the actual price at which the stop price was executed is called slippage.
This common risk management tool also enables you to avoid impulsive trading, closing your losing trades or winning trades too soon due to temporary price retracements. Your risk exposure is predetermined and gives you time to plan your trades well. Stop loss orders also minimise the possibilities of holding onto losing trades for far too long, at the expense of your remaining account balance.

 

What is a Trailing Stop Loss?

 

A trailing stop is a type of stop loss that secures profits as long as the market moves in the direction of your trade, and automatically closes the trade if the market moves against the trade. It is set with a specified distance from the market price, either measured as several points or pips.
Once the market moves in your favour with the number of points or pips specified, the trailing stop order is activated by placing the stop loss at the opening price (break-even) of the order. It will follow the market price within the specified points or pips and only close the order if the market moves backwards with the number of points or pips the trailing stop was maintaining.
Instead of watching their positions like a hawk, many day traders take advantage of this risk management feature to manage their rapidly traded positions.
Let’s take a look at an example to help illustrate a trailing stop loss. Let’s assume you bought TONGAAT HULLET shares at 50 rands per share, you would need to have a protective stop loss while keeping the trade running in the meanwhile.

 

Rather than set a specific stop loss order at a specific price, you might choose to apply a trailing stop loss at 10 rands or 10 points. This means if the price gets to 60 rands per share the trailing stop loss is activated at 50 rands per share (break-even). The trailing stop loss will follow the price maintaining a 10 rands or 10 points distance from the current market price. If the share price continues to rally to 80 rands per share, the trailing stop loss will also be trailing at 70 rands per share. The position will only be closed if the share price drops by 10 rands toward the trailing stop loss at 70 rands. The trader would have made a profit of 20 rands per share on the trade.

 

What is a Take Profit order?

 

A take-profit order operates similarly to a stop loss order. In a sense, they are the opposite of a stop loss order. Take-profit orders are triggered when the price of the instrument reaches a specified price. Once it is triggered, it automatically closes the open position on behalf of the trader.
Let’s go back to our example above. Your price target was to close the position at 80 rands per share. If the position panned out as anticipated on the TONGAAT HULLET share price, your position would close once the price reaches 80 rands per share and you will have made a profit of 30 rands per share, making 2400 rands on the trade.
The advantage of a take-profit order is that it helps you lock in your profit should the markets reverse. It means you don’t have to sit in front of your trading platform constantly monitoring your trades. Taking profit orders helps you stick to your trading plan. If you are seeking a specific profit level, the order automatically executes it without the risk of holding onto a trade for too long.

 

So, is using stop loss important?

 

No matter how much you learn about trading, and how experienced or successful you get, we are all human and are prone to emotions. This is why developing a trading strategy is crucial as it will guide you on how to manage your emotions through both winning and losing positions while directing you on how you can manage the risk exposure to your portfolio. You need to understand your risk tolerance level and factor in the risk exposure you are willing to take on each trade. Exit orders like stop loss should be an integral part of your trading risk management strategy.

Learn the terms

Stop loss order – A risk management tool you can use when trading to limit your losses

Take profit order – The opposite of stop loss, a take profit order closes the trade once it reaches a predetermined level when the trade is in profit.

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This information is written by Klips. The information is provided for general purposes only and does not consider any personal circumstances or objectives. Before acting on this material, you should consider whether it is suitable for your circumstances and, if necessary, seek professional advice. No representation or warranty is given as to the accuracy or completeness of this information. It does not constitute financial, investment or other advice on which you can rely. Any references to past performance, historical returns, future projections, and statistical forecasts are no guarantee of future returns or future performance. Klips will not be held responsible for any use that may be made of this information and for any consequences that may result from such use. Hence, any person relying on the information on this page does it at their own risk.

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