Saxo Group
You can make money from trading, but there are no guarantees. The financial markets are, by their very nature, unpredictable. No one knows for certain when the price of a security is going to rise or fall and, even if they did, it’s almost impossible to know how far the price will rise or fall.
You can do some research and use a variety of strategies to give yourself the best chance of making the right moves at the right times. However, there is always a chance things can go wrong. When they do, it’s important to have plan B. In trading, that plan B is a stop loss order. This risk management tool helps you limit your losses when trades don’t go your way.
Stop loss orders don’t stop all losses, but they are a way of limiting your losses.
An order is an instruction to buy or sell. Orders are usually placed over the phone or online. A trader, i.e. you, gives the order to a broker (the person/company between you and the financial markets). The order contains instructions you want the broker to carry out on your behalf.
For example, if you wanted to buy 100 shares in Amazon, you would place a “buy” order with a broker. The broker/brokerage’s software would put your order into an exchange. Once a counterparty match has been found, the order is fulfilled.
What’s a counterparty match? That’s just a fancy way of saying someone who has placed an opposing order. That’s how financial exchanges operate. Some people are buying, others are selling. A broker’s job is to place the order so the two parties can be matched on an exchange.
If you place a buy order, it gets matched with a seller on the exchange. If you place a sell order, it gets matched with a buyer on the exchange. That’s a very basic overview of how orders and exchanges work, but these are concepts you need to understand before you trade any financial security.
There are many types of order. All have the same underlying premise. However, the way the order is filled, when it expires, and how it’s closed will differ based on the type of order you place. Let's look at the types of orders available.:
Orders are instructions to a broker, and your broker needs to know whether you want to buy or sell. Equally, they need to know the security you’re going to buy or sell. Here at Saxo Bank, it’s possible to create orders for a variety of securities, including stocks, forex, CFDs, commodities, ETFs, and futures.
Besides telling the broker what you want to buy or sell, an order allows you to define multiple variables, including:
You can set all the above when you place an order. When you place a stop order, you can define all the above variables as well as a point at which the trade ends. That’s how you get a stop loss order.
A stop loss order is an instruction to kill (end) a trade once a specific target is reached or exceeded. As the name suggests, the price a trade stops at is below the amount you paid. When you’re making a loss, the trade gets stopped. The counter to a stop loss order is a take profit order. With a take-profit order, the trade is stopped once you make a certain amount of profit.
It’s important to explain the subtle difference between stop loss and stop limit orders.
A stop loss is an order that contains an instruction to buy (or sell) a security once its price reaches a certain point (i.e. a price lower than the amount you paid).
A stop limit is an order with two specific price points that have to be met.
The main difference between the two orders is the level of specificity. A stop loss order allows you to set a percentage loss. For example, you could set the stop loss to 10%. If the price of a security falls 10% or more from the price you paid, the order is cancelled.
A stop limit order requires you to define:
A stop limit order could look like this:
This means a trade will be stopped if the price hits 1.25 to 1.26 within a day. Having this level of control is great, but it can also lead to problems because the order is only executed if the prices are met. Essentially, the stop loss is conditional. If the price drops but doesn’t hit the specified stop or limit, the order continues.
Let’s say you placed the stop loss order when the price was 1.29. When trading starts the following day, the price opens at 1.22. You’re currently making a loss. However, because the price (1.22) isn’t within your stop limit range, the order remains live. Why? As we’ve said, the order will only end once a specific price has been reached.
In contrast, if you placed a stop loss order and the price opened at a point within the range you’d set, it would be closed. What you’ve got here is a situation where stop loss and stop limit orders can manage risk. Stop loss orders allow you to set a more general range and are, therefore, more flexible. Stop limit orders are more specific and, therefore, rigid. Both can be useful, so you need to choose the most appropriate one for your needs and level of experience.
To make sure you fully understand what a stop loss order is, here’s how one could look:
Security = stocks
Company = Amazon
Position = buy
Price = $100
Amount = 1
Stop loss = 10%
Based on the above variables, you’re buying one share in Amazon for $100. The stop loss is 10%. So, if the price of Amazon shares drops to $90 or less, the order is automatically closed. Why is the limit $90? Because 10% of 100 is 10:
100 x 0.1 = 10
100 – 10 = 90
In general, stop loss orders are used when you buy a security, i.e. you take a long position (going long means you want the price to increase in value). In this situation, the order gets closed once the security is sold. The broker/brokerage’s software will sell your security at the best available price once your predefined amount of loss has been reached.
It’s also possible to use stop loss orders when you sell. In this situation, your sell order is closed by the broker/brokerage’s software placing an offsetting purchase, i.e. the purchase cancels out the sell order. Using stop losses for sell orders (aka short positions) might not be as common, but it’s something you can do.
Stop loss orders are a way to manage risk. The truth is that you can’t eliminate all risk from trading. The financial markets are unpredictable. That means you can make a profit or lose money on a trade. However, experienced traders know that you can manage risk by controlling certain variables.
For example, you can carry out technical analysis before you take a position. You can read company reports and assess insights from experts before buying/selling stocks. You can only execute trades with money you can afford to lose. That doesn’t mean you will lose money or that you want to lose it. However, the money you use for trading should be expendable so that, if the worst happens, it won’t significantly affect your life.
These things give you more control over your trades and help to manage risk. Stop loss orders are another way of controlling the way you trade. These orders don’t stop you from losing money. What they will do, however, is limit your losses. You won’t lose more than expected because, as we’ve said, an order gets closed once the specified limit is met/exceeded.
If you’re going to trade online and stop loss orders are available, you should almost always use them. But keep in mind that, sometimes, stop loss orders can be problematic. For example, in highly volatile markets, stop loss orders aren’t always advisable. This is because prices can rise and fall dramatically in a short time.
Let’s say you’ve set a stop loss of 10% and you’re buying securities in a volatile market such as forex. The price of a security could drop 10% and, a minute later, increase in value by 15%. These swings can happen and they’re something people who trade in volatile markets accept. Using a stop loss order in these conditions will protect you from the dramatic downswings, but they’ll also prevent you from riding the upswings.
This doesn’t mean using stop loss orders in volatile markets is a bad idea. You shouldn’t implement this risk management tool without considering the bigger picture. It might be suitable for the current conditions, but it might not be.
Only you can make that decision. As long as you understand the fundamentals of stop loss orders, what they offer, why they’re used and the market conditions, you’ll be better prepared to make the best decisions for your investing goals.
Before you head into a live trading market and use this tool, we suggest using a broker’s demo software. When you create a demo account, you receive a virtual bankroll. This bankroll can buy and sell securities and you can also use it to place stop loss orders and get a feel for how they work.
Once you’re comfortable placing these orders and how the financial markets work in general, you can switch to a live account. It’s at this point that stop loss orders can help you manage risk and give you a better chance of making a profit when you trade online.
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