Risk management is an important concept In day trading and investing because of the significant risks involved. It is very vital because any trade you execute has a 50-50 chance of being profitable.
An important concept in risk management is known as using stop loss, one of the most useful orders in trading. In this article, we’ll look at everything you need to know about stop loss.
What is a stop loss?
stop loss is A tool that automatically pauses a file bearish or bullish trade When you reach a certain loss limit. For example, suppose a stock is trading at $10 and you decide to buy it. In this case, your trade will be profitable as long as the stock is above $10.
In this case, you can decide to protect the trade by setting a stop loss at $8. As a result, if the stock drops to $8, the broker will stop it automatically. In this case, You will be safe If the stock continues to fall below $8.
Stop Loss vs Trailing Stop Loss
Another important concept is known as a trailing stop. This is a tool that solves the main challenge that stop loss faces.
this challenge It happens when a profitable trade suddenly becomes unprofitable. For example, you can execute a buy trade at $10 and set the Take Profit at $14 and the Stop Loss at $6. In this case, the trade can be successful and the stock can go up to $13 and then suddenly drop to $6. In this case, your original profits will not be counted and your trade will have lost.
The Trailing Stop solves this challenge by Ensure that the original profits they are not loost when the stock drops sharply.
Rules for using stop loss
There are several rules to remember when using a stop loss. First, always make sure you have Designation stop loss In the right place. Doing this will help you not to make the mistake of setting a stop loss where it is not needed.
secondly, Always stick with stop loss And do not modify it during trade. This is where people go wrong. They set a stop loss and then adjust it if the trade is incurring a loss. They hope that the trade will have a turnaround and turn towards profitability.
Third, in most cases, for the benefits we mentioned above, use a trailing stop loss instead of a regular stop loss instead.
What is take profit?
The concept of stop loss is similar to the concept of take profit. Take Profit is an automatic tool trade stop when He. She Reach a certain profit limit.
For example, in the example above, you would place your take profit at $12. In this case, the broker will stop trading automatically when it goes up to $12. Most Successful traders always use stop loss and take profit In all their trades just to be safe.
SometimesAnd the These stations often work against them. For example, if the stock drops to the stop loss level and then resumes the uptrend, you will miss this opportunity.
A good example of this happened during the 2010 flash crash. At that time, stocks collapsed heavily and then resumed a strong uptrend. as a result of, Trades that have been discontinued using stop loss lost the chance for the emerging trend.
At the same time, if the arrow moves to Take profit and then keep going upit means that a The dealer will lose an opportunity.
How to set a stop loss
There are several ways to determine where to set your stop loss. One of the most popular methods is Determine the risk-reward ratio Then use it to set a stop loss.
For example, most people have a rule that they should not lose more than 5% of their account in one trade (the most conservative is 2%). Therefore, if you are opening a single trade, you should always make sure that the maximum drawdown you can get is 5%.
For example, suppose a stock is trading at $10 and you have $100,000 in your account. In this case, 5% of that money is $5,000. Therefore, when you open a trade, you must set the stop loss at a place where the maximum loss is this amount.
This is the simplest way to calculate the risk to reward ratio. some merchants Use a more complex process Incorporating their historical performance The ratio between winning and losing trades.
Another rule when setting a stop loss is that it should Not too close to the opening price. The reason for this is that the asset tends to waver after implementation. As a result, when you set up too close, it will likely get carried away and make you lose money.
Stop Loss for Traders vs. Investors
A common question is whether stop loss should be applied to both traders and investors. For starters, there is a file big difference between the two. A trader is someone who opens trades and holds them for a few hours. On the other hand, an investor buys an asset and then holds it for a few days, months or years.
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Both types of participants should always have risk management strategies in place. However, sometimes, Investor should be careful about using stop loss.
For example, if they start out in a long position at $10 and hope it goes up to $15, setting a stop loss at $8 can be a bit risky since stocks have a high probability of going down before continuing the uptrend.
for tradersOn the other hand, stop loss It’s a necessity For all trades to protect the potential downside.
In this article, we have looked at one of the most important topics in risk management. We have explained what a stop loss is and some key rules to use when using the tool.
Useful external resources
- Stop hunting in circulation is there, but it’s not what you would expect it to be – tradition