The stop-loss order : a trading safety belt

The stop-loss order allows the investor to cut their trading losses automatically when a certain price level is reached.

Stop-loss orders are an essential money management tool that allow the trader to manage risk exposure with precision, regardless of the market traded. Depending on their strategy, traders can use different types of stop orders, each with its advantages and disadvantages.

What is a stop-loss order ? Why place a stop-loss order ? How and where to place a stop-loss order ? What are the risks associated with stop-loss orders ?

Here is a complete summary of what you need to know to learn how to position your stop-loss orders properly.

What is a stop-loss (SL) order ?

By definition, a stop-loss order is a stock market order with a triggering threshold. Triggered automatically when a given price level is reached, it allows the investor to cut their losses when the stock price trend is not favorable. Although most investors generally use fixed stop orders, some traders prefer to use trailing stop orders. 

The trailing stop-loss orders allow to progressively protect winning positions by first bringing the stop level closer to the entry level to reduce the potential loss, and then by bringing the stop level closer to the current price level to secure part of the latent gains. Be aware that while stop-loss orders trigger the automatic closing of positions, it sometimes happens that the position is not closed at the mentioned price level. Indeed, during certain particularly rapid market movements or in the absence of sufficient trading volumes, the stop-loss order is only executed at the price level at which the first available counterparty is located (a buyer in the case of a sell order, or a seller in the case of a buy order). This risk, known as slippage, can be avoided by using a guaranteed stop-loss order, which as the name suggests, guarantees the trader that his position will be closed at the specified price level

Why use a stop-loss order ?

Stop-loss orders allow traders to be aware of their theoretical maximum loss ahead of time. Whether the position is opened in cash or with leverage, stop-loss orders are primarily intended to limit the amount of loss in case the trader makes a bad prediction. Although it is of course possible to use a "psychological stop loss" and close the position manually when the critical level is reached, it is still highly recommended to use standard automatic stop-loss orders. Indeed, in case of a fast moving market or a technical problem (Internet cut, battery failure, etc.) the manual closing may take time and be too late. Prevention is better than cure. Don't forget that in trading, risk diversification is managed through the succession of operations, since a losing operation can be covered by a next winning operation.

By placing a stop-loss order at a reasonable distance, the trader avoids putting all their eggs in one basket by betting too much on one trade.

Where to place your stop-loss order

At the risk of disappointing you, there is no ready-made answer to the question of where to place your stop-loss order. To answer this question, you need to take into account your trading strategy and market context. However, a few common sense rules can help you to position your stop-loss order correctly. The first is to take into account your win/loss ratio and your success rate in order to have a positive mathematical expectation.

Simply put, over the long term you should be able to win more than you lose. The distance of your stop-loss must therefore take into account the distance of your take-profit order. Thus, in the context of a scalping strategy, traders generally have win/loss ratios well below 1, which they then compensate by a success rate well above 50%.

On the other hand, within the framework of a day trading strategy, traders generally have profit/loss ratios greater than 1, thanks to which they manage to increase their trading portfolios over the medium and long term. The second principle is to take into account the volatility of the market. Indeed, refusing to take a sufficiently significant margin of error in a turbulent market means running the risk of seeing one's stop-loss triggered by a "wick", i.e. by a short-lived and insignificant price movement. Once the trader has identified the critical level at which they consider their trading scenario invalidated, they must then analyze the historical or implied volatility of the market to estimate the margin of error. Technical indicators such as standard deviation or Bollinger bands can help here.

Finally, in the context of trailing stop-losses, the trader can then rely on other types of technical indicators in order to follow the current trend: moving averages, Donchian channels, or Fractals.

Whatever your use of stop-loss orders, keep in mind that they will only be useful if they are not deactivated or removed during the trade! Indeed, too many traders give in to the temptation of changing their initial scenario along the way... If this situation speaks to you, and if you have trouble keeping control, think about automatic trading.