At the moment when we consider entering the world of trading, there are many concepts that we must know before putting our money at risk, such as what stop loss is. If these words do not sound familiar to you, you better keep reading this article, as it is key to being able to do our trading activities well.
We will explain what stop loss is and how it is used. You will see that its importance is very relevant and can help us a lot to prepare our trading strategies. Besides, it’s always good to learn something new.
If we learn to use the stop loss well, we will not only ensure that we do not lose more money than we are willing to lose, but we can also ensure a minimum profit margin if things go well.
What is a stop loss in trading?
A stop-loss order is an order placed with a broker to buy or sell a specific stock once the stock reaches a certain price. A stop-loss is designed to limit an investor’s loss on a security position. For example, setting a stop-loss order for 10% below the price at which you bought the stock will limit your loss to 10%. This is according to investopedia.
As we have already mentioned before, there are some concepts in trading that are essential to do well. That is why we are going to explain what stop loss is.
Basically it is an order that we give to our broker to literally “stop loss”.
It’s no secret that there is a golden rule that all stock speculators should follow: Always keep risk under control. In order to comply with this golden rule, we always have to know in advance how much we are willing to lose before making a trade. Once we have the figure clear, we can give the order to our broker to open the position.
Immediately after giving the purchase or sale order, it is time to leave a stop loss to prevent losses from exceeding the figure of what we are willing to lose. It is a buy or sell order that will be executed only when the price goes below or against the limit that can cause us the maximum loss that we are willing to have. That is to say: The operation that we have carried out will be “cut” before we can suffer larger losses.
It is important that we keep in mind that the orders that are not executed are free. Therefore, controlling the risk in our stock market operations does not cost us anything, but on the other hand, we will save ourselves many bad moments and disappointments.
How is a stop loss used?
Now that we know what a stop loss is, we are going to explain how it is used. We have already commented that it is an order that protects us from having losses greater than what we are willing to have and, in this way, control the risk that it entails.
However, we will have certain doubts:
- Where should we place it initially?
- And how to move it as the price advances?
We have to be very clear about the answer to these two questions before entering the market.
With a medium-term strategy, we have two options to enter: Pullback or breakout. The stop loss will be placed according to the entry we make. In these two cases, the approaches and the emergency exits are different.
In the event of a resistance breakout, we must place the stop loss right at the support or resistance line that we define, leaving a small margin. To do this we will look at the shadows belonging to the next candles, we will place the order below, more than a tick away.
It is advisable to avoid round numbers. This way we will not allow hesitation regarding the price. If it were the case that the break is not authentic, it is not at all convenient for us to be in a value that will surely end up collapsing. On the contrary, if it turns out that the breakout is genuine, the price will explode in our favor, leaving the stop loss behind.
The other entry option is through the pullback to the weekly moving average. This average is simply an indicator that will help us estimate the value, not the price. Therefore, if we do not adjust this indicator, it will not help us at all.
When we have adjusted it, we will know from what level the price should not drop. Now the question is to try to place the stop loss below the low corresponding to the bounce, as before.
Adjust the stop loss as the price advances
Always keep in mind that the market is constantly moving. All prices will rise. When it is up it is called a swing and when it is down it is called a pullback. They will occur one after another until the last pullback is no longer a pullback, causing the weekly moving average to change direction as price crosses it from top to bottom.
Therefore, what we must do is place the stop loss below the last relevant low each time a rebound on the value has been confirmed.
At this point we must remember that the adjusted moving average, but not a generic thirty-week average, gives us a fairly accurate idea of where the value is. In this way we can change and adjust the stop loss under each bounce that is confirmed on the value.
This will make it much easier for us to take advantage of the direction of our trade and we will lose at most what we could have gained on the last swing.
This technique, called trailing stop, consists of updating the stop loss at a few defensive points as the price rises or falls in our favor. This will ensure that we maintain a minimum of profits. To carry out this technique well, we will always end up moving the stop loss in the same direction as the price; we will never move it away from it.
We must be very careful with brokers that offer a tool called “trailing stop loss”. This applies a fixed rule that allows us, in theory, to forget about tracking the price. An example would be to chase the price always leaving a 5% distance. It is not recommended to use this tool.
As we can see, the stop loss is really essential for trading. If we operate in the fx market or stock market without using the stop loss, it is as if we are driving a car without brakes. So we should always use it.