Stop loss is a type of order through which a trader specifies to his/her broker to exit the holding position automatically, on the event that price moves contrary to the expectation. It is crafted to minimize the loss when unprecedented moves happen (it does 90% of the time) and the trader is not caught off-guard.
For example, let us say you’re holding a long position in the EUR/USD bought at 1.14000. And it moves to 1.13000.
If you’re confident that it will bounce back and head to your anticipated price, then the relevance of stop-loss order doesn’t come into play.
However, if you’re skeptical that the price will go down further, then you’re going to book your losses and exit.
Stop order simplifies this process. It lets you define the maximum loss amount you are ready to incur in the particular trade, beforehand. And if it happens to reach that price, the broker automatically exits your position.
Stop order becoming stop loss order
You can’t expect a trader to sit before the trading station to guard his/her trade (although they do it all day).
Hence, a trader instructs the broker to close out the position through the stop order or stop (my) loss order, in case of a mishap.
Why stop loss order? Why not the limit order?
The emphatical design of the order processing system is such that the current market price (or Last traded price) is the price point where the highest bid and lowest ask order meets.
The bid order must not exceed the lowest ask price and ask order must not exceed the highest bid.
If you place an order, contrary to the above notion, your broker simply treats it as a market order and executes it, since the ultimate motto for the broker is to provide the best available price to you.
Some exchanges or brokers (around the world) vehemently dissuade the act of placing a bid higher than lowest ask price and an ask order below the highest bid.
Hence, naturally, the system permits you to place your order for the anticipated price (target) but not for the unanticipated price (stop loss).
The advanced stop-loss order takes care of this problem for you.
Illustration of the stop-loss order
The above candlestick chart is an illustration of how the stop loss order works. If you take a buy entry at 1.14500, assuming you follow technical analysis, you expect the price to be bullish as long as the low at 1.14300 holds. So, your obvious choice for a stop loss would be to place it 10 pips below the 1.14300. Once you set it, you don’t want to sit all day and strenuously gaze the charts. In a way, it reduces your stress level and lets you the risk associated with the trade.
Safeguards Profit too
Suppose, the ambitious trader in you wants to squeeze out of the trade or say, the price has not reached your target ‘yet’, but in decent profits. In both cases, the prudent choice is to safeguard your unrealized gains.
The market is a paradox; you never know what happens next. It’s better to be safe than sorry (proverb).
You can modify the stop loss to a higher value, which you feel will hold, as long as the trend prevails.
Remember, the LTP, current bid and ask prices are the only concern for the order management system and not your entry price.
In this case, it becomes a Trailing stop loss order.
Most brokers allow you to incrementally increase (or decrease for short trades) the trailing stop loss order as the price moves in your favor.
Point to note on stop loss order
Stop loss order has a trigger price.
The trigger price of a buy stop-loss order must be higher than the last traded price (LTP). Likewise, sell stop loss order must be below the LTP.
The order is deemed to be inactive until the trigger price is reached.
When the price reaches the trigger price, the order becomes active.
Types of Stop loss orders
The dormant stop loss order comes live upon reaching the trigger price.
Upon becoming active, the broker treats it just like a regular order.
Hence, the stop loss order can be either market or limit order.
Metatrader doesn’t permit stop-loss limit orders for the exit. However, it allows a stop limit order to enter a trade.
The Market vs. Limit in Stop loss order
Both the orders differ significantly and carry significant risk too. Hence, traders need to exert caution before choosing the type.
A market order guarantees instant execution of order upon reaching the trigger price whereas the limit order doesn’t. It bargains for the exact price.
Bargaining is ideal in any other scenario, but it isn’t here since a trader expects further drastic moves once the triggered price activates.
There is ample chance for a limit order to not be executed in gapping moves or high volatile conditions.
So, a market order serves the purpose in these situations.
However, at times, the market tends to overreact initially, come to its senses later and corrects the move or makes a pullback during which stop limit order seems enough.
Let go of the myth that market order gets executed precisely at the trigger price. Stop loss fills the order only at the next available price. Going by the theory, it can be any price, even 100 or 200 pips far-fetched from the trigger price. But it doesn’t happen actually. Can you leave that to chance?
A trader has to weigh his choices whether to bargain for a few minuscule pips or exit his losing trade at the earliest and cut short his losses.
Improvising the stop order to start order
Most conventional technical set-ups suggest to buy above or sell below a particular value.
And when the market breaks a support or resistance level, traders fear of getting trapped at the highs (or lows) and tend to let go of the entry point, merely witnessing the rally with awe.
To nullify fear and instigate discipline into your trading system, you can opt for buy stop or sell stop order in advance, when you spot such setups.
Through a buy stop order, you can place an entry order above the LTP and it triggers only upon reaching the specified. Likewise, sell stop order initiates a sell trade.
Thus, stop orders initiate trades as well, against its fundamental notion of closing out the open position.
Take Profit order
The take profit order doesn’t have any of these gruesome caveats. The market entertains your creativity to the maximum. According to the wise, one can set a target of twice or thrice the value of the stop loss.
‘To err is human’ – mistakes and errors are part and parcel of our day to day lives. But, we should not let that error result into an irreparable costly loss. What took years for you to earn, will take only minutes for the market to take it from you. Stop loss order is the unsung hero of the trading fraternity, saving the dime, time and time again.