What is a stop loss when it comes to trading?
Stop loss is a basic term when it comes to CFD trading and investment in general. Whether you are a novice or a professional forex trader, everyone needs to use stop loss orders. Stop loss and take profit orders are market orders used to respect a money management plan.
After reading this article, you will understand:
- What a stop loss is
- The types of stop loss orders
- How to define a good stop loss on MetaTrader
- Examples of stop-loss calculations
- Advanced stop losses
What is a stop loss order? – Definition
What does stop loss mean?
A stop loss (SL) is an automatic market order used by traders to exit positions when trades are going against them. As its name indicates, it stops losses. These orders are usually used to define the maximum loss an investor is willing to accept for a trading position.
How to set a stop loss properly
There are several stop loss categories. Depending on the broker, we can find:
- Guaranteed stop losses
- Non-guaranteed stop losses
A guaranteed stop loss means the broker guarantees to close out the position at the exact defined price. These orders usually aren't free because the broker will have to pay the difference between the stop loss level and the level where the stop loss order was actually filled. It works like an insurance; the broker charges a fee and covers the trader if the stop loss is executed beyond the initial level.
According to the execution mode, we distinguish:
- Classic stop losses
- Trailing stop losses
We'll get back on these two different types further in this article.
The broker can also set a minimum distance between the opening price and the stop loss level. In this case, we can find:
- Stop losses with a minimum distance
- Stop losses without any minimum distance
If you're looking to scalp or trade the economic calendar, you should choose a broker that doesn't impose any minimum distance between the opening and the closing price. This allows you to quickly enter and exit the market when only looking for small moves. Admiral Markets doesn't impose any minimum distance.
Classic and trailing stop losses are available on the MetaTrader 4 and 5 platforms, the Webtrader platform and even on smartphone applications.
In addition, if you don't want your stop loss orders to be triggered on gaps, you just need to activate the volatility protection setting through your back office.
How to trade with stop losses
Trailing stop loss – MT4
Stop losses aren't only used to cut losses; they can also be used to protect profits.
A trailing stop is a stop loss order that follows market prices in their evolution. To be as efficient as possible, the trading platform needs to be opened. Therefore, if you're using trailing stops make sure to leave your trading platform opened.
On the other hand, if your trading activity is intensive it might be good to use a VPS. It is a virtual server which allows you to close your platform while keeping the advantages of trailing stops.
Trailing stops follow live market prices when a trade is evolving favorably and freezes when the market is going against it. For a buy position, a trailing stop will move up as long as the price is too, and will freeze when the price goes down. If the price retraces the maximum level you've set, the position will automatically be closed.
For a short position, the trailing stop moves down as long as the price is too, and freezes when the price goes up. Here is a video that explains how to set trailing stop orders on the MetaTrader 4 platform.
With the Mini Terminal, can I use a trailing stop and a classic stop at the same time?
Of course, you can.
For the same trading position, we can define a classic stop loss (which won't move) and a trailing stop which will follow market prices (if going in favor of the trade). The position will be closed when one of both stop losses is hit. In order to do so, the Admiral Markets MetaTrader Supreme Edition is required.
Factors to take into account when setting a stop loss
It seems obvious that each investor trading for their own account wishes to make a profit through his activity. In order to do so, it is important to understand that investing and trading on the markets is a risky activity. That's why it is essential to protect operations using market orders. If you're looking for steps to follow in order to set your stop loss, you should ask yourself:
- Which capital can I allow myself to trade with?
- What is the maximum loss I am willing to accept on this position?
- What is the current volatility of the financial instrument I'm about to trade?
- Which strategy am I going to use?
- Which stop loss suits my strategy the best; classic or trailing?
These questions may seem simple, but many novice traders forget to ask themselves these particular questions. They trade the same way they would gamble, and it often results in losses.
Online trading is quite similar to classic trading, we invest a certain amount and try to make a good return out of it. CFD trading allows the use of leverage but it can be misleading if you don't understand the way it works and if you don't use stop losses to protect your capital.
Some traders will define stop losses according to their trading capital, while others will define it using technical indicators (the Average True Range for example).
When setting a stop loss, there are three main factors to take into consideration:
- The time horizon of the investment (scalping, day trading, swing trading, long-term investment)
- The market we invest on (forex, indexes, stocks)
- The daily volatility of the financial instrument we're investing on
How to display the trailing stop for MAC
MetaTrader 4 and 5 for Mac allow you to use a trailing stop. In order to set one, you just need to right-click on the opened position in the Terminal part of the forex trading platform.
If using the Apple mouse, you may need to check the settings in order to be able to right-click. Here is an illustration of what your settings should be like for the right-click to function.
Stop-Loss example on the DAX 30
DAX 30 buy order:
- Opening level = 11 200 points
- Stop-loss level = 11 190 points
- Stop-loss in points: 10 points
For a buy order, the stop-loss level is always below the opening price of the operation.
DAX 30 sell order:
- Opening level = 11 200 points
- Stop-loss level = 11 210 points
- Stop-loss in points: 10 points
For a sell order, the stop-loss level is always above the opening price of the operation.
Risks of trading without stop-loss
Using a stop-loss or not is a personal choice, and some traders chose to trade without one. This solution is only conceivable if you are able to monitor your positions. Traders who use low or no leverage at all can also allow themselves to trade without a stop-loss.
In normal market conditions, stop-losses have no execution problem. If you're buying a stock at 50 $ with a stop loss at 47,50 $, the stop loss will be filled when the stock loses 5%.
However, when markets are highly volatile stop losses can be triggered because of the spread. Therefore, the stop loss will be filled at the first bid or ask price available.
A solution can be to take into consideration the financial instrument's daily or weekly volatility. For example, if the average daily volatility of an instrument is 2%, setting a stop-loss at only 1% can be very risky as the chances to trigger it will be higher.
Stop loss advantages and disadvantages
You'll find here the different advantages and disadvantages of using a stop-loss when trading. You can try both solutions on a demonstration account in order to see what suits you the best.
- Usually free to use
- Helps to control and limit losses
- Helps to respect a precise money management
- Easy to use and to set
- No need to monitor positions at all time
- Helps to get rid of emotions (regarding losses)
- Often be triggered due to high volatility
- Not guaranteed when gaps occur
- Not always free to use
There are two important elements to keep in mind regarding stop-losses:
- They determine the success ratio of your strategy. When triggered, a position will be considered as a loss (even when the stop loss is protecting a profit).
- They also determine the risk to reward ratio of each position. For tight stop losses, it is easy to get a risk-reward ratio higher than 1:1.
How to deal with stop losses when scalping
Each trader has its own opinion regarding the use of a stop loss. It also depends a lot on the strategy used.
Scalp traders who are able to look at their charts all day may think that not using a stop loss is the best way, as it can be triggered on small market moves. On the other hand, more conservative traders may think that setting a stop loss before opening a position is better in order to manage unexpected market moves. This can be useful for news scalpers trading the economic calendar.
How to set a stop loss for swing trading
If you're doing long-term trading (swing trading) without leverage, you may not use stop losses as you already know the maximal loss you are willing to accept.
However, you may consider setting one (according to the acceptable loss) if you don't have access to your trading account during a certain period of time (holidays for example).
How to set a stop loss for day trading
If you're doing day or intraday trading, you may not be able to always monitor your positions and therefore consider stop losses as a must (and you're probably right).
Setting a stop loss is a good and wise solution for novice traders who are not able to monitor their positions. It is also logic in order to follow a money management strategy.
We highly recommend using stop losses if you're a beginner. It is important to be able to manage your risk and your exposition when trading (as it is when investing in general).
The stop-loss can be set in relation to the financial instrument you're trading, its daily volatility, the size of your trading account or the maximal loss you're willing to accept.
What can a stop loss be based on?
Each trader can define a stop loss according to different elements:
- A fixed distance
- An indicator
Whatever the element you use to define a stop loss, the most important is to have a profitable strategy on a long-term period.
Advanced stop losses
Time-based stop losses
It may not be very common, but a time-based stop-loss can be efficient for more than one forex strategy.
Here, the stop loss can be placed above or below the high or low of the last hour. Therefore, if the price crosses the last high (for a sell position) or the last low (for a buy position) it is better to close the trade as chances are high it would result in a more important loss.
You can find a buy and a sell example below.
Source: CFD USD/JPY; 5-minute chart, MT5 Admiral Markets, 09/04/18 and 06/04/18
- The first image represents a buy position. The signal was given by the hourly close of the Japanese candlestick above the 20-period exponential moving average (in a bullish trend, with the 20 EMA above the 50 EMA).
The stop loss is the red line, just below the last hourly low between 8.00 AM and 9.00 AM.
- The second image represents a sell position. The signal was given by the hourly close of the Japanese candlestick below the 20-period exponential moving average (in a bearish trend, with the 20 EMA below the 50 EMA).
The stop loss is the red line, just above the last hourly high between 7.00 PM and 8.00 PM.
Gaps and stop losses
A gap is a lack of quotations between two prices. It occurs when a candle opens at a higher or lower level than where the previous one closed. On the forex market, we can have weekend gaps. It means that the Friday evening exchange rate (when the market closes) is different from the Sunday evening exchange rate (when the market re-opens).
On indexes, gaps can happen every day if the opening price is different than the closing price (indexes close every night while forex only closes on Fridays evening). Why is it important to know?
If a gap opens above the stop loss for a sell position of below it for a buy position, the stop loss will be filled at the first available price. Therefore, the stop-loss isn't guaranteed. It is very rare to find a broker who guarantees stop-losses on gaps (if it does, it is probably not free).
As a client, you should wonder if it is worth it to pay for such a service (will it have a real impact on your profit?).
Guaranteed and non-guaranteed stop losses
Classic stop losses are usually non-guaranteed and free (even if some brokers charge for them).
What is a guaranteed stop-loss?
It is like an insurance provided by the broker; it charges a fee and if the stop loss is filled at a different level than the one wanted, the broker refunds you the difference.
Why choose a guaranteed stop-loss?
This way, you can be sure the stop loss will represent the exact loss you are willing to accept. It can be useful in order to respect a perfect money management plan.
Would the stop loss be guaranteed in any situation?
Not really. As we just saw before, most stop losses aren't guaranteed when gaps occur, or when the market's volatility is very high (when news are released for example). You can check on the broker's website the general conditions page to know when a stop loss is guaranteed and when it is not. A very good example of exceptional market conditions where a stop loss would not be guaranteed by the broker is the Swiss Franc crisis which happened in January 2015.
Non-guaranteed stop losses are just classic stop losses, the execution level is not guaranteed. However, most of the time stop losses are filled at the correct level if you're broker provides a good execution speed. In order to better understand how stop losses work, the best is to open a demonstration account.