"Stop losses are generally trading orders that you place with your broker. When you place a stop loss, you are telling your broker to stop your losses beyond the price level that you set. When price falls to your stop loss level, the stop loss order triggers and exits you from the market. Stop loss orders are a way to manage your risk and it also tells you when you should cut your losses short. Disciplined traders always enter the market with a stop loss order and a take profit order. This keeps them focused on their analysis. There are different ways stop loss orders can be set. In this article, we explain in detail the different approaches to setting your stop loss order. But before that, we will quickly explain the two main types of stop loss orders that can be used and the difference between these two types."
A stop loss order is one of the most crucial order types that you will use as a trader. This is the order type that tells your broker when to kill or exit your trade if your trade was running into a loss.
As you can see, a stop loss order is part and parcel of the risk management that you will be using right from the start. Without a stop loss order, you would have to stay glued to your trading screen. Using a stop loss order, you can simply set the order at the price you want. There is no need for you to stay at your trading terminal.
When price reaches the particular price level that you set in your stop loss, the stops automatically kick in and exit you from the trade. This prevents you from taking on further losses in the market.
It is therefore, crucial to understand the different types of stop loss orders that are available. We can primarily classify stop loss orders into two types.
- Market
- Limit
A market stop loss order is as the name suggests. With this type of a stop loss order, you are basically exiting at the current market price. But this is not the ideal way to trade. If you are using a stop loss order market, it basically means that either you do not have a set stop loss order, or that you do not have enough confidence in your analysis.
Many beginners tend to use stop loss at market for a number of reasons. It could also be a psychological factor. For example, you might come across a forum posting where someone is confidently telling you the opposite to what your analysis shows.
This lack of confidence will lead you into believing that your analysis is wrong, and you could end up stopping your trade at market.
A limit stop loss order is the most commonly used type of a stop loss. In this order type, you will be setting this at the time of entry. If price falls to this stop loss level, your trade is automatically closed. This prevents you from taking on further losses.
Within the limit order type for the stop loss, there are different ways you can calculate where to place your stop loss orders. The most commonly used methods to derive at the stop loss price include:
Stop loss based on a percentage value: In one of our previous articles, we outlined how risk management principles can be used. Using position sizing, you can set your stop loss to risk no more than 1% of your capital. Based on this one percent rule, you can then set your lot size. Depending on the lot size, the stop loss order can be set so that you do not risk more than 1% of your capital.
Stop loss based on Risk/Reward set up: There are times when you will want to trade smaller positions. In this case, it isn’t necessary that you should set your stop loss order to a 1% threshold. Rather, you can set your stop loss order based on the risk to reward ratio. The general rule of thumb is to use a risk to reward ratio of 1:2 at the very least. This means that for every $1 in value that you risk, you expect to make $2 in profit. You can calculate your risk/reward set up such that your stop losses follow the 1:2 rule or even higher.
Stop loss based on volatility: Market volatility tends to rise and fall at regular intervals. When you trade smaller time frame charts such as the 5-minute chart, up to the 1-hour chart, you can see that the volatility will move prices around. In such situations, you can set your stop loss order based on the volatility. Traders tend to use a technical indicator called the Average True Range or the ATR indicator. Based on this indicator’s values, traders set their stop loss accordingly.
Stop loss based on technical analysis: Technical analysis of course is the main starting point when it comes to trading. Thus, you can also set your stop loss based on what the technical analysis of the price chart tells you. Depending on whether you are trading with indicators or price and chart patterns, stop losses can also be set to specific values. In this instance, your stop loss is set to a stage such that when it is hit, it would invalidate your analysis and view of the markets.
