Stop-Loss Concept

If you trade in the stock market (or any other market), you must be aware of the concept of stop-losses. A stop-loss is a very effective tool for protecting your trade.

Stop-loss In Trading

A trading plan must have at least three prices to be complete.

The price at which you will enter,
The price at which your stop-loss will be set, and
The price(s) at which your profit objective will be set (s).

In this article, we will focus solely on the second point, "Stop-loss in Trading." The first thing that we want to cover with you is—

what stop-loss actually is?

A stop-loss order is an instruction to a broker to buy or sell a security at a specific price.

A stop-loss order closes a losing position when the price reaches the specified level.

Set a sell stop-loss order if you are long, and a buy stop-loss order if you are short.

For example, suppose you purchased a stock of ABC at $150 because you believe the price will rise, but there is a possibility that the price will fall (to $130 or less).

In that case, you want to limit your loss, which is where the stop-loss comes in. To protect your capital, enter an order in the system to sell the stock as soon as it reaches $130 or less.

There are two ways to do it: either follow the price and close the trade manually when it falls to $130 or less, which is known as a "mental stop," or simply set a stop-loss level at $130, which closes your trade automatically when the price reaches your order.

❝ A properly places stop-loss is truly the starting point of a successful trade

— Nial Fuller

Types of Stop-loss

Two different types of stop-loss orders exist—

Sell-stop order
Buy-stop order

4 different approach of stop-losses

How much should the stop-loss level be? Such a query is typical when one is trading. The majority of traders set the stop-loss order value using the percentage rule.
The decision to utilize a stop-loss order method is a personal one, and choosing an appropriate stop-loss order value is more important. The following are 4 distinct stop-loss order approach that you could apply:

First Approach

First is technical stop-loss. In this situation, you set your stop-loss based only on the price action chart, which includes chart patterns, trendlines, Fibonacci levels, Elliott Wave levels, and support and resistance areas, to name a few.

Second Approach

Second is Stop-loss based on affordability. In this scenario, you confine yourself to just 2 or 3 deals while limiting your total number of trades. Then, rather than relying on technical levels, you set your stop-losses far deeper.

Third Approach

The third approach is known as a trailing stop-loss. When you are in profit and want to hold on for a little longer, you can use trailing stop losses to protect a portion of your profits.

If the price reverses and begins to move against you, a trailing stop will remain at the most recent level, limiting your losses or locking in unrealized profits.

Fourth Approach

The final approach is percentage stop. A percentage stops limit the total risk of a trade by based on a percentage of your trading account. A trader with a $20,000 account who wants to risk 3% of his trading account on a single trade, for example, could set a stop-loss at a level that ensures his total potential loss is $600.

Combining technical stop-loss with percentage stops can provide much better results; for example, a trader would place a stop-loss based on an important technical level and manage his total risk by adjusting the position size of the trade.

Advantages of Stop-Loss Order

Discipline is promoted, and stop-loss protects your decision-making from emotional influences.
It helps in the maintenance of risk and reward. The primary goal of a stop-loss order is to reduce risk exposure. Traders are strongly advised to use stop-loss orders at all times when entering a trade in order to limit their risk and reward.
Reduced losses and the use of a stop-loss order will protect these investors from a huge loss in the stock market.
You don't have to monitor how a stock is performing on a daily basis because it acts as an automation tool.

Disadvantages of Stop-Loss Orders

Short-term fluctuations can activate stop-losses, and adds risk to the investors.
Stop-loss orders can force an investor to close a deal too soon, limiting his or her profit potential.
Your broker may charge you for using stop-loss orders at times.
Investors Need to Decide The Stock Price: There are no hard and fast rules for deciding where to place stops.
Many brokers will not let you place a stop order on certain securities, such as penny stocks.
Stop-loss orders are not foolproof; in a fast-moving market, the stop-loss trade may not be executed.

How to find stop-loss level?

Stop-loss levels can be determined using various techniques such as technical indicators, trendlines, or S&R levels.

Moving averages, such as the 50-day moving average (DMA), 100-day DMA, and 200-day DMA, help to determine the stop loss level.
Technical indicators such as the Relative Strength Index (RSI) and Moving Average Convergence Divergence (MACD), as well as their crossover levels, provide a good indication of when the breakdown will occur.
Trendline support can also indicate rising or falling support, which can be used as a stop-loss price.

How to place a stop-loss order?

A stop-loss order is placed in the same way as any other type of order. Begin by selecting "buy" or "sell."
Although there may be minor differences between brokers, your order ticket may default to a "market" order type at this point. Change "Market" to "Stop" wherever it says it. Then you simply select your stop price and place your order.

Why 'Stop-loss' is important?

Let's take an example to understand this. The chart pattern below is a Descending Triangle formed in the EURGBP pair on September 28th, 21 in the 30 minute time frame.

Descending Triangle

A Descending Triangle is a bearish chart pattern created in technical analysis by connecting a series of lower highs with one trend line and a series of lows with a second horizontal trend line.

Explanation :

     
       Forex pair  : EURGBP
       Time frame  : 30 min. (28 Sep'21)
       Pattern     : Descending Triangle
       Signal      : Descending Triangle. gives bearish signal
       Expectation : price will fall (↓)
       Position    : Short
       Reality     : appreciation in price (↑)
       Result      : Stoploss hit 
                     (loss with 1:7 risk reward ratio)
       Lesson      : Trade with confirmation 
                     (respect your stoploss, 
                     no revenge trading)
       Ideal entry : Breakout & Retest, 
                     when support become resistance

The trade, as shown in the chart, goes against your strategy. To protect your capital, you must use a technique known as stop-loss.

Keypoints-

When an investor does not want the pressure of monitoring a security on a daily basis, a stop-loss is used.
Set stop-losses at critical support and resistance levels.
Trailing stops are useful in trend-following strategies.
Change your stop-loss orders to lock in profits.
Determine the size of your position based on your stop-loss.
Your profit target should be greater than your stop-loss.
If the position is volatile, you can set a stop-loss about 10-15% above/below where you started the short/long sale.
One disadvantage is that a short-term price fluctuation could trigger the stop and cause an unnecessary sale.

Final words

Stop-loss orders can have a significant impact on your trading, risk management, and performance. Traders are strongly advised to use stop-loss orders at all times when entering a trade in order to limit their risk and avoid a potentially catastrophic loss.
It is a great option and a personal choice for day traders to use in order to avoid losses after a price drop.