What is a stop-loss order and how does it work?

What is a stop-loss order and how does it work?

A stop-loss order is an order used to limit the potential loss on your trade. By placing a stop-loss order, you give your broker the instruction to close your trade once it reaches a specified price. Stop-loss orders are widely used by traders, as they can help to prevent unexpected losses.

To benefit from stop-loss orders, you will have to give your broker the necessary instructions, either before you place the trader or after the trade is already running. Stop-loss orders can be modified at any point, even after the trade has been placed already.

Stop-loss meaning

The term "stop-loss" comes from the fact that this type of order closes your trade to prevent further losses. For example, you bought gold at the price of $2,500 with a stop-loss order at $2,480. Gold drops to $2,470 shortly after, but since you had a stop-loss order placed at $2,480, your trade closed at this price. Instead of having a floating loss of $30, you have now a realised loss of $20. The order prevented a deeper loss due to the trade being stopped out, which is why it is called the "stop-loss" order.

Types of stop-loss orders

Market stop

Market stop is the most used type of stop-loss order. Once a specified price is reached, the order becomes a market order. This is the reason that traders might experience slippage when using stop-loss orders. Market orders are orders that are executed at the best available price at the moment, but during times of high volatility, the price at which the order is executed could be worse than expected.

Using the previous example, let’s assume you have placed a stop-loss order of $2,480 for your gold trade. With the market moving against you, the best possible scenario is that your stop-loss order gets executed at $2,480 — the exact price that you have set. However, gold could see significant volatility and your order might be executed at, for example, $2,479, causing you an additional loss of $1.

The key characteristic of a market stop order is that it is immediately executed once the stop-loss price is reached, however, since it is a market order, the actual fill will depend on liquidity and market conditions.

Stop-limit

A stop-limit order is a combination of a stop order and a limit order; thus, it involves two components: the stop price and the limit price. Once the stop price is triggered, the order is converted into a limit order that executes at the specified price or better.

The benefit of a stop-limit order is that you control the price at which the order will be executed. The disadvantage is that the order could end up not being executed, despite the price level being hit. This could be for example due to the spread widening significantly due to high volatility.

Trailing stop

A trailing stop is a type of stop-loss order that keeps adjusting along with price fluctuations in the market. The idea behind it is to protect profits while still giving traders the opportunity to benefit from further price movements in their favor.

A trailing stop is typically expressed in points, pips, or percentages. For example, if you have been holding a long (buy) position and the price is moving higher, the trailing stop will keep moving higher as per your specified distance. However, if the market moves against you, the trailing stop will not move, acting as a regular stop loss order.

Let us assume Trader A buys EUR/USD at 1.10 with a 100-pip trailing stop. If EUR/USD moves to 1.11, the stop-loss order will automatically be adjusted from 1.09 to 1.10. The stop-loss order will remain at 1.10 until EUR/USD moves another 100 pips in your favor, which would be at 1.12.

Trader B bought USD/JPY at 150 with a 50-pip trailing stop. However, USD/JPY starts moving lower, reaching 149.70 by the end of the day. Trader B now has an unrealised loss of 30 pips, but his stop-loss order has remained stationary at 149.50.

The advantages of trailing stops are that they give you more flexibility when it comes to risk management, and it can automate the process of having to adjust stop loss orders. The disadvantages are that you could end up getting stopped out of your trade early and leave profits on the table. Trailing stops — like regular stop-loss orders — are also subject to slippage when markets are illiquid.

How does a stop-loss work?

An order is an instruction to the broker to either buy or sell a specific instrument. Nowadays, orders are primarily placed online, either through the broker’s trading platform or mobile app.

By placing a stop-loss order, you are giving the broker instructions to close an existing trade once it has reached a specific price level. Should the instrument hit that specified price level, the order will be converted to a market order, and executed immediately, at the best available price, and your trade will be closed out.

The great thing about stop-loss orders is that there is nothing else you must do once you have set it unless you want to adjust the price level. The broker will automatically execute the order once the price level is met.

How to use a stop-loss?

Every trading plan should include risk management rules, including how to use stop-loss orders. A popular way to determine an appropriate level where to set your stop-loss order is to use technical analysis. This allows you to place the stop-loss order objectively, and to focus on the markets.

For example, if you set risk management rules that allow you to risk $100 per trade, and you have identified a suitable stop-loss level on the charts, you would want to adjust your position size accordingly, so that you can meet both requirements.

This is particularly important for traders with smaller account balances, as they can avoid taking large risks just to meet the wider stop-loss requirement in a trade.

Key support and resistance levels are a popular method to determine where a stop-loss order should be placed, and it is used even by traders relying primarily on fundamental analysis. For example, if you are looking to buy gold at $2,400 and you have identified a significant level of support at $2,350, you may consider placing the stop-loss order just below it, anticipating that even if gold retreats in the short term, it could bounce off the $2,350 level, leaving your trade intact.

How to set stop-loss levels

In MetaTrader 4/5, you will be presented with the option to set a stop-loss order before placing your trade, this applies to both market and limit orders.

When opening the trade window, set the price level under "Stop Loss".

You can also do it after the trade is already open, by clicking on "Modify" and then setting the appropriate price level.

Stop-loss order examples

Stock trade stop-loss

Nvidia is trading at $100 per share. You believe the stock will rise in the short term, and hence decide to buy the Nvidia at the current market price.

You are willing to risk $10 per share, which means your stop-loss order would be set at $90. To protect your profit, you used a trailing stop — meaning every time Nvidia moves higher by $10, your stop loss order will be adjusted accordingly.

Scenario 1: Nvidia moves to $110 the following day. Your original stop-loss order is automatically from $90 to $100. In the worst-case scenario, you would now be stopped out at your original entry price (assuming there is no slippage). If Nvidia moves to $120, your stop-loss order will be adjusted to $110, and so on.

Scenario 2: Unfortunately, Nvidia crashed due to unexpected market news, triggering your stop-loss order at $90. Since the price of Nvidia shares never moved $10 or more in your favor, your stop-loss order remains stagnant at the original price level of $90.

Forex trade stop-loss

Your analysis tells you that the price of silver should be moving higher in the coming days, and you decide to capitalise on this by buying XAG/USD.

Your entry is at 27.44, and looking at the charts, you identified a key level of support at 26.41. You therefore decide to place your stop-loss order just below this key level, at 26.20, to allow some room in case we see a test of this level.

You set your take-profit order at $29.20 — the next key resistance level.

Why use a stop-loss in trading?

Financial markets are volatile, and trading is a risky activity. A stop-loss order is an important tool that helps traders to minimise their losses and stay disciplined. Even if you were monitoring your trades all the time, there could be moments when markets become so volatile that you would not even stand a chance to react on time, and you could end up losing your entire account balance.

Additionally, if you were to trade without a stop-loss, due to a potentially unlimited loss, you could feel more pressure or desire to micro-manage your position rather than sticking to your trading plan. This could — aside from causing you financial losses — also seriously hinder your progress in becoming a successful trader.

Advantages of stop-loss

1) The main advantage of using stop-loss orders is that they can help minimise losses.

2) It gives traders the time to focus on other things, knowing that even if the markets move against them, they have some insurance in place in the form of the stop-loss order.

3) Using stop-loss orders helps traders to fine-tune their risk management skills and stick to their trading plan.

Disadvantages of stop-loss

1) Slippage can occur, and there is no guarantee for where your order will be filled. Most of the time, stop-loss orders get executed at or very near the specified price. During times of high volatility and/or low liquidity, the stop-loss order could be executed at a significantly worse price than anticipated, leaving you with a larger loss than you planned for. 

2) Determining the appropriate stop-loss level can be difficult, particularly for beginners. You want to leave enough room to avoid getting stopped out quickly, but you will also want to prevent excessive losses. Position sizing can help a lot, as you can adjust your trade size and find the right balance between both.

Conclusion

Stop-loss orders are an important tool for traders as they help them to manage their risk and limit potential losses. There can be unexpected moves in the markets at any time, which makes it important to use stop-loss orders, even if a trader is actively monitoring all trades. That said, it is important to understand that even stop-loss orders have limitations, and slippage can occur.

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This information is not to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any trading strategy. It has been prepared without taking your objectives, financial situation, or needs into account. Any references to past performance and forecasts are not reliable indicators of future results. Axi makes no representation and assumes no liability regarding the accuracy and completeness of the content in this publication. Readers should seek their own advice.