How to Use Stop Loss Orders in Trading?

Stop loss order is the order that automatically closes your trade once it reaches a specified price target. Learn all about it here.

Table of Contents:
🔹What Is a Stop Loss Order?
🔹Why Stop Loss Orders Matter?
🔹Setting Stop Loss Levels
🔹Types of Stop Loss Orders
🔹Adjusting Your Stop Loss Orders
🔹Summary

In trading, reducing risks is oftentimes all that matters to achieving success. One of the essential tools to protect your investments from steep or unexpected losses is the stop loss order. Understanding how to use stop loss orders can unlock your path to profitability by allowing you to balance your risk and reward ratio. In other words, with the right stop loss setup, you can shoot for asymmetrical risk returns by keeping your drawdown small and letting your profits run.

Let’s dive into the exciting world of trading and see how stop loss orders can be your greatest ally in trading.


📍What Is a Stop Loss Order?

A stop loss order is an essential risk management tool used by traders to limit potential losses on a trade. By using a stop loss order, you instruct your broker to automatically sell the asset you’re holding when it reaches a predetermined price level that is below your purchase price, or entry.

A stop loss order allows you to control your losses and protect your investments so you don’t have to sit glued to the screen all the time.


📍Why Stop Loss Orders Matter

Stop loss orders play a big role in risk management. These easy-to-set trading tools help traders stick to predefined risk tolerance levels by limiting the amount of money they are willing to lose on any given trade.

Without a stop loss order in place, traders may give in to emotional decision-making during periods of market volatility, leading to potential losses. If you have a hard time cutting your losses If you have a hard time cutting your losses when —ok, we get it, you're a bigshot— IF positions go against you, setting a stop loss when you enter the market will do the hard work for you.

➡️Risk Management: One of the primary reasons stop loss orders are essential is because they help traders manage risk effectively. This is crucial in volatile markets where prices can fluctuate rapidly, as it prevents significant losses that could otherwise occur if trades were left unattended.

➡️Emotional Control: Trading can evoke strong emotions such as fear and greed, which can lead to irrational decision-making. Without a stop loss order in place, traders may be tempted to hold onto losing positions in the hope that the market will reverse in their favor.

➡️Peace of Mind: Knowing that there is a safety net in place can provide traders with peace of mind. Stop loss orders allow you to do your thing in the market without obsessively watching charts and tickers. Set your stop loss orders and focus on other aspects of your market study like catching up on the latest market-moving news and analysis.

➡️Preventing Catastrophic Losses: In extreme market conditions, prices can experience sudden and significant declines. Without stop loss orders, traders risk experiencing catastrophic losses that could wipe out a significant portion of their capital.

➡️Enforcing Discipline: Successful trading requires discipline and adherence to a well-defined trading plan. Stop loss orders help enforce discipline by striving to ensure that traders stick to their predetermined risk management rules. If trading is about discipline and consistency, then stop loss orders are the stepping stone to success.


📍Setting Stop Loss Levels

Choosing the appropriate stop loss level is a critical aspect of using stop loss orders effectively. Traders should consider various factors, including their risk tolerance, investment objectives, market conditions, and the volatility of the asset being traded.

A common approach is to set the stop loss below a significant support level or a recent low in an uptrend (if you have a long position) and above a significant resistance level or a recent high in a downtrend (if you have a short position).

Example: Suppose you purchase shares of a company called X (not Elon Musk’s privately held X Corp., which he created by rebranding Twitter) at $50 per share. You estimate that a 5% decline in the stock price would indicate a potential trend reversal. Therefore, you set your stop loss order at $47.50 per share to limit your potential loss to 5% of your investment.


📍Types of Stop Loss Orders

There are several types of stop loss orders that traders can utilize, each with its own special characteristics. The most common types include:

➡️Market Stop Loss: a type of stop loss order that triggers a market order to sell the instrument at the prevailing market price once the stop loss level is reached.

➡️Stop Limit: with a stop limit order, you have to deal with two types of prices. The first one is the price that will trigger a sell and the limit price. But instead of converting your order into a sell based on current market prices, you set a limit price.

➡️Trailing Stop Loss: A trailing stop loss order is dynamically adjusted based on the movement of the instrument’s price. It allows traders to lock in profits while giving the trade room to move in their favor.

Example: You purchase shares of a big tech company at $100 per share, and the stock price then rises to $120 per share. You set a trailing stop loss order with a 10% trail. If the stock price declines by 10% from its peak, the trailing stop loss order will trigger, selling the shares at prevailing market prices.


📍Adjusting Stop Loss Orders

While setting stop loss orders is essential, monitoring and adjusting them as market conditions evolve is equally important. Traders should regularly reassess their stop loss levels to account for changes in volatility, price action, and overall market sentiment. Additionally, as profits accumulate, trailing stop loss orders should be adjusted to protect gains and minimize potential losses.


📍Summary

In conclusion, stop loss orders are one of the most essential and effective tools for traders seeking to manage risk and preserve and grow capital in the challenging world of trading. By understanding how to use stop loss orders effectively, you can rein in emotional decision-making, protect your investments, and increase your chances of long-term success.

Whether you're a novice or an experienced trader, integrating stop loss orders into your trading strategy is a smart approach to navigate the twists and turns of the financial markets. Remember, trading involves inherent risks, but with proper risk management techniques like stop loss orders, you can tilt the odds of success in your favor.


❓Do you use stop loss orders when trading? Which type ? Let us know in the comments ⬇️