Stop Loss: Limit Losses and Secure Profits

When entering a trade, it is important not to go in blindly, but to plan the trade based on a strategy, with a trading plan and appropriate risk management:

In today’s post, I will go into more detail about the Stop Loss (part of any efficient risk management), how it works, what types of Stops there are and what the risks are.

The Stop Loss (also called a Stop) is an order that is used to protect a position by limiting potential losses by automatically closing the position when a certain level is reached and protecting profits when the Stop is pulled beyond the entry price. The use of Stop Loss orders is crucial in almost all market environments and investment strategies to protect capital and ensure long-term profitability.

Simply put, it is important to set at least these three parameters before entering a trade: entry, Stop Loss and take profit.

Charts by TakeProfit.com

“Standard” Stop Loss

In this example, one could have gone short on the breakout from the upper Bollinger Band after the Doji (entry). Here, the RSI was also divergent, which is another indicator for falling prices.

With a box projection, the same range of the Doji could have been projected upwards in order to set the Stop Loss.

Now, one could have taken profits at various points (Partial Take Profits). Partials are part of many risk management strategies that help to secure profits quickly and achieve a good average profit. For example, the first partial TP could have been taken at the middle Bollinger Band and at the same time the Stop could have been pulled to break even (BE/entry price). That way, we could have been stopped out, but secured a small profit. Small profits do add up! Other good levels for partial profits would have been the lower Bollinger Band and the 3 lows to the left.

Trailing Stop Loss

However, if we had opted for a Trailing Stop Loss in this case, our statistics would look completely different.

A Trailing Stop is also a Stop Loss order that is automatically adjusted by your broker at a predetermined distance. This means that after each new high, while your position is still running, the Stop is pulled further towards BE or even into profit.

Depending on the distance you have set and whether you close the position completely (100%), take partial TPs or let your trade run until your trailing Stop is reached, your trade results in a completely different RR. Suppose we had also used the length of the Doji as a Stop for our Trailing Stop, using a box projection. In our example, we would have been stopped out in the first to third candle, depending on the entry price. It must be said that trailing Stops are usually not placed too tightly, but at longer intervals in order to allow for smaller corrections, but to capture the overall momentum.

Guaranteed Stop Loss (GSL)

In order to use GSLs, there are a few things that we as traders need to keep in mind. GSLs are used to avoid the risk of slippage. Slippage is a market phenomenon that can occur in extremely volatile industries. These are, for example, indices, cryptocurrencies and commodities, where economic events (announced in various economic calendars) are known to bring high volatility to the market and cause gaps.

With a “Standard” Stop, there is a risk that, although you have placed a Stop, it will not be triggered or will be triggered at a worse price (slippage) if the price gaps against your position. Of course, this messes up the statistics, which we always want to keep nice and clean, and accordingly the RR, which means that we need longer to recoup our loss.

This risk is usually assumed by the broker through a higher fee or a larger spread. Figuratively speaking, the GSL is your insurance from the broker (insurer) against water damage (slippage).

Knock-Outs

Knock-outs, similar to GSLs, have a fixed Stop Loss that cannot be exceeded or breached and are therefore one of the best hedges against the so-called gap risk. A knock-out level is set before the start of the trade, at which point the product expires worthless.

These structured products are particularly popular with experienced and precise traders, as the leverage effect offers disproportionately high profit opportunities. Precise because you only have to pay the part you are prepared to lose, as the rest of the leverage or the capital deposited for the trade is taken over by the issuer of the product and therefore higher holding fees are incurred the longer you hold the trade. Therefore, this product should only be used if you already have experience in trading and expect a strong price movement in the near future.

Investors. This order is used to limit potential losses by automatically closing a position when the market reaches a certain price. The use of Stop Loss orders is crucial in almost all market environments and investment strategies to protect capital and ensure long-term profitability.

At the beginning of a trade

Integration of Stop Loss orders in trading strategies

Stop Loss orders are an essential part of any trading strategy. However, incorporating them into a trading strategy requires care and thought in order to effectively manage risk. Here are some strategies for using Stop Loss orders:

• Risk management: Determine the maximum percentage of the portfolio you are willing to risk and set the Stop Loss accordingly. This will prevent you from losing more than you can afford. Note that depending on your strategy and holding period, a higher or lower percentage may be appropriate. For example, if you are scalping on the S15 (15 second chart), you can risk a lower percentage than if you are looking for an entry on the daily chart (D1/Daily) and want to hold the trade for weeks or months. For short-term trades (scalping, day trading and short term trades up to one week) no more than 1-3% is normally risked and for trades with a longer holding period (swing trades) no more than 5%.

• Technical analysis: Use technical indicators and chart patterns to determine sensible Stop Loss levels. For example, Stops could be set just below important support or resistance levels. For example, if we are in wave 2 of a standard Elliot impulse, wave 2 may only correct wave 1 by a maximum of 99.9 %. However, it is important to bear in mind that there are small deviations in the chart between different brokers, which is why it is advisable to allow for a small buffer. A buffer is also important due to the different spreads of different instruments.

• Break Even Stops: After a position has reached a certain profit and a partial TP has been executed, the Stop Loss can be adjusted to the entry price (Break Even) to ensure that the position does not result in a loss and that a small profit has been secured. If the chart goes against you for a short time, you can re-enter the trade at any time (in the case of a Break Even Stop also at a lower entry price).

• Scaling and position management: When entering into larger positions, as with partial TPs, it can be useful to set several Stop Losses in order to close parts of the position gradually and spread risks. These partial Stops can also be adjusted to the planned partial take profits. In other words, tighter Stops and earlier tightening for the first TPs and looser Stops and later tightening for the partial TPs that you want to allow to run.

Conclusion

Advantages and Disadvantages of Stop Loss Orders

Benefits:

• Limit losses: Stop Loss orders protect your capital by preventing large losses.
• Reduce emotional trading: They help to avoid emotional decisions as the exit points are predetermined (IMPORTANT: Once the Stop is set, you should not pull it further into a loss to avoid being stopped out in the event of a trend reversal. For risk management reasons, it is often better to re-enter the trade at a later date with new parameters and a better RR).
• Automation: They enable automated handling of positions and allow you to take the dog for a walk and sleep peacefully at night 🙂

Disadvantages/Risks:

• Market volatility: In very volatile market conditions, Stop Loss orders may be triggered too early.
• Slippage: The difference between the expected price of a Stop and the price at which the Stop is actually executed. Slippage often occurs in volatile or illiquid markets.
• Execution risk and price gapping: The risk that an order is not executed at the expected price or not executed at all. It can also happen that your position is closed even though it has not yet technically reached your Stop. This can be caused by rapid market movements, low liquidity or technical problems. Price gapping refers to the phenomenon where the price of a security jumps from one trading level to the next without any transactions in between, which can lead to unexpected executions, especially in the event of a gap down, a sudden significant drop in price.

In addition to slippage and the risk of early execution, Stop Loss orders can also be a psychological trap. You could be lulled into a false sense of security by believing that the Stop Loss will fully protect you from large losses, which can lead to underestimating other risks.

There are also various hedging options to protect a position. However, we will go into more detail in a later post to give you a detailed overview of the different options and their applications.

Overall, Stop Loss orders are a useful tool in any trader’s risk management, but it is crucial that you fully understand the risks associated with them and adjust your strategies accordingly to minimize any unwanted effects.