How To Use A Stop Loss For Risk Management
To be a successful trader or investor you need to manage your risk. One of the most important risk management tools in trading is the Stop Loss. In this post, we’ll explore the Stop Loss in more detail.
What is a “Stop Loss”?
A Stop Loss is exactly what it sounds like: a way to stop losses when trading. This is important when trading volatile assets like Bitcoin or small-cap stocks. For example, suppose you buy a bunch of stocks at £1.00 because your analysis suggests the price will go up.
But what if you are wrong and the price goes down instead? To protect your investment, you could set a Stop Loss at £0.95. So, if the stock price goes down by 5%, your stocks are automatically sold.
In doing this, you limit your maximum potential loss on the investment to 5%. But you still have the potential to earn the same profit on your investment if the stock price goes up.
How to choose a Stop Loss level
The stock market industry standard level of a stop is around 6-8% below the purchase price. However, the right level varies depending on what type of trader you are. If you are more conservative, you would set the stop-loss closer to the buy price. Less conservative, further from the buy price.
Serious traders use technical analysis to determine their stop levels. One of the most common ways to do this is to set the stop just below the price support level. The chart below shows an example of how this could be done with Bitcoin.
Example of price support and setting a Stop Loss. Bitcoin chart.
What are “Trailing Stops”?
A trailing Stop Loss is a way of raising the stop as a trade becomes more profitable. This allows you to “bank” some profits without sacrificing further upside.
For example, say you bought silver at $14 an ounce and initially set your stop at $13.20. A few days later, the price of silver is $14.50. Your analysis suggests the price will go up more, but you want to lock in some profits in case the price goes down again.
You could now raise your Stop Loss to, say, $14.25. This way, if the silver price goes down, you still keep $0.25 in profit.
What about short selling?
When you buy an asset, you want the price to go up. You set the stop below the price you bought the asset to minimise your downside.
Shorting an asset is just the opposite. In this case, you profit when the price goes down. Therefore, you would set the Stop Loss above the trade entry price in the case of going short.
Remember with a long trade you would often set the stop just below the price support line. Oppositely with a short trade, you could set the Stop Loss at or just above the resistance line. We can see an example of this in the below diagram:
Example of price resistance and setting a Stop Loss. Short Bitcoin trade.
I’ll conclude this post with one last point: it’s not always best to set your stops too “tightly” (as in too close to your entry price).
Prices seldom move up or down in a straight line, and it’s highly unlikely that your trade will always move exactly in the direction you want it to. Therefore, setting your stops too tight can sometimes do more harm than good!
