When entering a trade, the main goal is to make a profit, but there is also a crucial need to prevent losses, so you don’t lose whatever little profit you have made and even your capital.
Stop loss is an important risk management tool in the financial market that helps traders and investors limit their potential losses.
At its core, stop loss order is a predetermined instruction to sell or buy an asset once its price reaches a specific level.
This strategy helps investors and traders to safeguard their investments by automatically exiting a trade once the market moves against their position.
While mapping out your trading strategy, it is crucial that you identify your stop loss point. Your stop loss point shows the maximum amount of loss you are willing to take from a trade.
In this article we have outlined the importance of stop loss, it’s disadvantages, and methods of setting stop loss.
The major importance of using stop loss is risk management. By setting a predetermined exit point, you can reduce potential losses, preventing a significant decline in the value of your portfolio during adverse market conditions.
For example, you purchase 100 shares of Tsela at $200 per share. Knowing that the market can go against you, you decide to set a stop loss order at $195.
If Tsela shares starts to decline and reaches $195, the stop loss order is automatically triggered and your trade is closed. This way, you are protected from future losses.
If you didn’t place a stop loss order and Tsela shares continued to decline in value after reaching $195, you could face substantial losses.
Stop loss also helps you preserve your capital by preventing large losses on individual trades. This helps to ensure you have financial resources to participate in future trades.
Another importance of stop loss is that it helps you overcome making emotional decisions.
Before entering a trade, you most likely mapped out a strategy, but during the trade, price movement can make you change your trading strategy impulsively.
Stop loss helps you stay with your predetermined trading strategy and reduces your chances of making emotional decisions.
Also, stop loss helps you save time, it eliminates the need to constantly monitor the market, seeing that you can set your exit point in advance.
Determining stop loss point is an important part of your trading strategy, you do not want to set it too high where it can easily be triggered by normal market volatility or too low where it will be triggered after you have made so much losses.
When determining stop loss, one of the first things you want to do is assess your risk tolerance, how many percentage of your portfolio are you willing to risk on a single trade.
Another thing you want to do is to analyse the historical volatility of the asset. If the underlying asset is highly volatile then you may want to consider a wider stop loss to account for price fluctuations. However, for less volatile assets, a tighter stop loss can be considered.
To determine stop loss, you also want to make use of technical indicators and chart patterns to identify support and resistance levels on the chart. Setting stop loss below the support or above the resistance can provide protection against market fluctuations.
and adjust stop loss level based on the evolving market conditions.
While stop loss is a risk management tool, it can also expose you to some risk.
One of the major risk of stop loss is market volatility, when you set stop loss too close to the
current price, it may be triggered by short term market noise leading to premature exits.
Another thing to note is that your stop loss can be affected by slippage. Slippage occurs when the price you set as stop loss differs from the expected price.
During periods of high volatility or gap in price, the actual execution may be less favourable than the stop loss order result in more losses.
There is also a risk of false breakout, where prices briefly move beyound the support or resistance level before reversing. If you set stop loss too close to these levels, there is a risk if being stopped out due to the false signal.
Despite the disadvantages, stop loss orders are still a crucial risk management tool and as a trader or an investor, you should consider the disadvantages of stop loss when setting your stop loss limit.
Stop loss can be used to trade during periods of both high and low volatility and for short or long term trades. Although stop loss may pose concerns of slippage, false breakout and other possible disadvantages, it is an important risk management tool and should be part of your trading strategy.
Stop loss order is an order to automatically sell an asset when price falls below a predetermined level. One the predetermined exit point is triggered, it initiates a market order to either sell or buy the asset. The main goal of stop loss is to limit potential losses on a trade and provide discipline that aids risk mitigation.
Yes, stop loss is a good idea, they help with risk management, prevention of emotional decisions, trading discipline, and protection during volatility.
Traders may decide to avoid stop loss due to fear of slippage, intraday volatility, temporary price fluctuations, avoidance for over reliance on automation, and all of the disadvantages that stop loss poses.