For many retail investors starting with trading, it is common to hold a losing position too long or see their profit slip back into a loss, resulting in wider than expected losses, or forgoing profits.
In this article, we explore the usage of stop-loss orders as a mechanism to help traders manage their exposure and risk when placing trades.
What are stop-loss orders?
A stop-loss order is a financial mechanism that enables an investor to specify a particular condition under which an unfavourable position is automatically sold. As such, stop-loss orders help to possibly prevent behavioural biases of holding on to losing trades and allow traders to realise their losses in a disciplined and planned manner.
This will help to protect overall investment returns and manage the downside risk of any trading strategy.
Main types of stop-loss orders
Stop-loss orders can either be set at a fixed price value or as a percentage that adjusts as the price fluctuates.
A stop-loss set at a price creates a trigger to sell once the price falls below this fixed value. A stop-loss set at a percentage, also known as a trailing stop-loss, follows the current market and price in comparison to its peak since the order was placed, flexibly adjusting as the price moves.
In other words, the trailing stop-loss moves up but not down with the price, much like a high-water mark.
When comparing both order types, the trailing stop-loss order is more advantageous as it allows traders the flexibility of reacting alongside fast market movements in prices.
For instance, if a market is moving in a trader’s favour, the trailing stop-loss level moves along with the trend, maintaining a fixed percentage of the prevailing price without the trader needing to adjust it manually.
Some platforms provide guaranteed stop-loss orders, providing traders with complete certainty of closing out a trade at a specific price without running the risk of slippage. These orders usually come with a premium and are refunded in full if it is not executed at the specific price.
Advantages of stop-loss orders
- Stop-loss orders deliver the ability to enter or exit trades at a future stop price which traders can set.
- They allow decision-making to be free from emotional influences by keeping a disciplined approach to managing risks and exposure for each trade if the market moves unfavourably against one’s position.
- With stop-loss orders, traders do not have to make contemporaneous selling decisions, which may be challenging when the markets are moving quickly, or if multiple positions are being monitored at the same time.
- They can help improve overall investment returns by protecting the downside risks and securing profit, helping to maintain a disciplined trading strategy.
- Stop-loss orders may not be as efficient as expected if new relevant information affecting prices is not incorporated.
- Though the trader will not incur any further loss on the specific investment, he also gives up the opportunity for his investment to recover during periods of high price fluctuations.
- The stop-loss level could be triggered during a period of short-term fluctuation in prices before traders are able to react accordingly.
How to place a stop-loss order when trading?
As we have already established, a stop-loss is designed to limit a trader’s loss on a financial security’s position, thus serving as salvation for one’s deposits.
It is advisable for traders to set a stop-loss order at a level that the trader is comfortable with losing when considered together with all other positions and the entire trading strategy as a whole.
Risks to consider when using a stop-loss order
In periods of unpredictable and high price fluctuations, there could be scenarios where stop prices are not executed, or they may be executed at prices substantially below the investors’ price expectations, especially if the market moves rapidly.
Another risk to consider is that stop orders may be triggered by short-lived and dramatic price changes, and prematurely exiting positions that would otherwise be profitable.
Retail traders and investors should understand that if their stop-loss order is triggered under such circumstances, they could be selling at an undesirable price, even though the market price could eventually stabilise and continue in its favor.
Alternatives to stop-loss orders
A limit order is an instruction to enter a trade at a specific price. Traders can place a limit order to buy at a lower price than the current market level, or to sell at a higher price than the current market level.
Limit orders can only be fulfilled when the market price reaches the specified price and thus has execution uncertainty, meaning that the trader will not know if and when the limit order might be executed.
A stop-limit order is essentially a conditional trade over a defined time frame that combines the features of a stop-loss order with those of a limit order to mitigate risk.
For instance, the stop-limit order can be executed at a specified price, or after a given stop-loss price has been reached, subsequently, the stop-limit order essentially becomes a limit order to purchase or sell at the limit price or better. This however runs the same risk of execution uncertainty as a limit order if the price exceeds the limit.
A market order is a request by a trader to purchase or sell a security at the best available price prevalent in the current market. Generally, this request type is usually made through a broker and is considered the fastest and most reliable way to enter or exit trades.
In summary, stop-loss orders help prevent behavioural biases but may lead to some efficiency losses. Their strength comes from their ability to allow investors to limit their losses by prompting the sales of losing investments and letting losses build up.
They are an essential part of developing a trading strategy for most. New investors are encouraged to explore the option of stop-loss orders to stay on track and practice sticking to set parameters in a trading strategy and prevent emotion from clouding their judgement.
For more information, reach us at Ortega Capital.