A Comprehensive Guide to Using a Stop Loss: Empowering Your Trading Strategy
But before we dig any deeper you must know that a stop loss is not always guaranteed to get executed and most traders don't realize this.
Understanding Stop Loss
Defining Stop Loss
A stop-loss order is a directive given to a broker to buy or sell a particular stock once it reaches a specific price. The primary purpose of a stop-loss order is to limit an investor's potential loss on a position. For instance, if you establish a stop-loss order for 10% below the price you bought the stock, your loss should be in most cased confined to 10%.
Stop Loss in Action
Let's say you recently purchased a stock, futures or option contract, a commodity, a Forex pair, etc at fixed price per contract. Following the purchase, you put a stop-loss order at fixed price below your entry. If price dips to or below your defined stop loss price, your contracts will be sold and closed at the prevailing market price.
Stop-Loss Vs. Stop-Limit Orders
Stop-loss orders and stop-limit orders might appear similar, yet they have a crucial distinction. In a stop-limit order, two prices are specified: the stop price and the limit price. The order becomes a limit order that will execute only at the limit price or better, instead of becoming a market order to sell.
Diversifying Stop Loss: The Use of Option Contracts
An alternative to using stop orders is leveraging option contracts. Options can limit downside losses during market swings, offering another layer of protection to your investment portfolio.
Advantages of Using Stop-Loss Orders
Cost-Effective Risk Management
The most notable advantage of a stop-loss order is its cost-effectiveness. Your regular commission is charged only once the stop-loss price has been met and the contracts needs to be sold. Some might say that a stop-loss order can somewhat be seen as an insurance policy for your trade.
Reduced Need for Constant Monitoring
Another perk of stop-loss orders is that they can free you from the need to constantly monitor your trade's performance. This feature is particularly beneficial when you cannot watch your trade for an extended period, such as when your internet connectivity is limited or you're away from technology.
Stop-loss orders can serve as a shield against emotional decision-making. Often, investors and traders develop an emotional attachment to their trades, which can lead to unwise decisions. A stop-loss order can help keep your judgment clear and focused.
A good rule of thumb is to not move your stop loss level once you're in a trade.
The Downside of Stop-Loss Orders
Triggering Unnecessary Sales
One of the main drawbacks of stop-loss orders is that a short-term price fluctuation could activate the stop price. This could result in an unnecessary sale. Therefore, it's crucial to set your stop-loss percentage in a way that allows for price fluctuations while also mitigating as much downside risk as possible.
In our price action trading courses we advocate that a stop loss should be set "outside of price structure" but within your personal risk tolerance.
Variable Sell Price
When your stop price is reached, your stop order becomes a market order. This means that the price at which you sell may differ significantly from the stop price, particularly in a fast-moving market.
Locking In Profits with Stop-Loss Orders
Traditionally, stop-loss orders are perceived as a way to prevent losses. However, they can also be utilized to lock in profits. In this scenario, you can use a "trailing stop". The stop order then trails price as it moves up for sell orders, or down for buy orders.
Interaction with Market Makers
Market makers play a critical role in the execution of stop-loss orders. As professional traders, they are paid to provide liquidity to the market. Market makers use theoretical pricing models and algorithms to help set fair prices for where they'd be willing to buy or sell at any given point in time.
The Role of Market Makers in Stop-Loss Execution
Bridging the Gap
Market makers bridge the gap between buyers and sellers. They provide liquidity to the market, making it easier for retail and institutional traders to execute trades.
Arbitrage and Risk Management
Market makers engage in arbitrage, using proprietary algorithms and mathematical models. This rapid-fire buying and selling of the same or similar securities across markets helps capture and close up price inefficiencies.
Market Conditions When Stop Losses Don't Get Executed
There are certain market conditions where stop losses may not get executed. For instance, if the market is moving rapidly, your stop order might not get filled at your predetermined stop price.
Furthermore, stop-limit orders carry additional potential risks. While these orders can guarantee a price limit, the trade may not be executed at all if the market price quickly surpasses the limit price.
The Influence of Retail Traders
Market makers can anticipate where stop losses are likely to be placed with reasonable accuracy. Many retail day traders tend to set stop losses around the same areas like around EMAs, VWAP, or a key level. They exploit this pattern to trigger stop losses and then continue in the direction predicted.
The Stop-Loss Trap
At certain times of the day, your stop losses are more vulnerable to being triggered. These periods include just after the market opens, between midday and early afternoon when the morning rush is over, and in the 15 minutes before the market closes.
A stop-loss order is a powerful tool with substantial advantages when used effectively. Whether to prevent excessive losses or lock in profits, nearly all investing and trading styles can benefit from this strategy. It can provide protection for your investments and trades.
And if you don't remember anything else from this free Market Insights article know this: Stop losses are never guaranteed to get filled. Simply search for "flash crash" and your eyes will be opened to the potential limitations of a stop loss.