Using Stop Loss Orders
To limit your risk on a trade, you need an exit plan. And when a trade goes against you, a stop loss order is a crucial part of that plan. A stop loss is an offsetting order that exits your trade once a certain price level is reached.
Let's assume you buy the euro/U.S. dollar (EUR/USD) currency pair at 1.1015, expecting it to rise. With this expectation, you place a stop loss at 1.1005 because your foreign exchange (forex) strategy indicates that if the price falls to this level, it could go even lower before it goes higher. The stop loss order theoretically caps your risk at 10 pips per lot traded. (A pip is the fourth decimal place in a currency price, or 1/100 of 1 percent, which is also called a basis point. The exception to this definition is the Japanese yen; a pip in yen pricing is the second decimal place, or 1 percentage point.)
Using stop loss orders is a bit more complicated than that simple example, however. There are different methods for carrying them out and different types that have their own pros and cons.
Regular and Worst-Case Stop Loss Orders
There are two common ways traders use stop loss orders:
- A stop loss is used to exit every trade. The trader sets a stop loss on each trade at a price level at which they wish to exit what has become a losing trade. This is a regular stop loss and is used as the only exit plan for a losing trade.
- A trader manually exits trades as opportunities arise and conditions change but may also set a worst case stop loss order to limit losses in case a manual exit isn't possible.
The stop loss, whether regular or worst case, serves to get you out of a position if you're disconnected from your broker because of an internet or power outage or you need to step away from your computer but don't want to exit your trade quite yet.
Stop loss orders execute automatically, which is often a good thing during a losing trade. Humans have a tendency to hang on to losing trades (loss aversion), so having a stop loss in place ensures the trader is limiting their losses to a small percentage of their account capital. At the minimum, a worst-case stop loss should always be used.
Stop Loss Market Order
A regular or worst case stop loss is how a stop loss is used. Stop loss order types—market or limit—are the types of stop loss orders typically used.
The most common type of stop loss order is a stop loss market order. When the price of an asset reaches or goes past your stop loss price, a market order is automatically sent by your broker to close the position at the current price, whatever it may be.
Under most conditions, with a stock, currency pair, or other asset with lots of volume, your stop loss order will "fill" at, or very close to, the stop loss price you set. However, in fast-moving market conditions (when important news has come out, for example) or with a very thinly traded stock or asset, where the trade is actually exited could be quite different than the expected stop loss price.
This situation is called slippage and can result in a worse price than expected. It's one of the cons of trading with a stop loss market order, and for that reason, some traders prefer to manually exit trades. They believe they are better off manually exiting when conditions are favorable, as opposed to a market stop loss order automatically exiting their position in unknown conditions.
Stop Loss Limit Order
Another stop loss order type is the stop loss limit order. When the price of an asset reaches your stop loss price, a limit order is automatically sent by your broker to close the position at the stop loss price or a better price. Unlike the stop loss market order, which will close the trade at any price, the stop loss limit order will close it only at the stop loss price or better. This eliminates the slippage problem (which, again, isn't really a problem most of the time) but creates a bigger one: It doesn't get you out of the trade when the price is moving aggressively against you.
If you went long on a stock at $50 and placed a stop loss limit order at $49.90, and the price moved to $49.88, with no one willing to buy your shares at $49.90, you need to hope someone now fills your limit order at $49.90. If the price keeps dropping without your order being filled, your loss continues to grow, potentially well beyond the point you wanted to get out at. And in that scenario, the point of a stop loss order—to get you out of a losing position—is negated.
The Best Stop Loss Order Strategy
If you're going to use a stop loss order, use stop loss market orders, not stop loss limit orders. If you're concerned about slippage for a particular trade, then use a stop loss market order as your worse case stop loss and exit manually when conditions are favorable.
For most traders under most circumstances, using a stop loss market order as their regular stop loss is highly beneficial. It assures you get out of losing trades automatically, so you aren't tempted to gamble and let losses mount.
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