All trading is inherently risky. Sometimes even the most experienced investors look for extra ‘tricks of the trade’ to help them achieve the best results possible. There are a few measures that can be taken to reduce your exposure to risk and help streamline the process.
You may also find that these methods might save you from having to closely monitor the movements of the market on a day-to-day basis too, like protective trading orders. Think of stop-loss and take-profit orders as a type of insurance policy - you’re hoping for the best outcome, but you should also plan for the worst.
Most reputable brokers offer their users a chance to set stop-loss and take-profit orders in one form or another. Let's take a brief look at both methods and see how they can be an option that will help you become a more confident and profitable trader.
Understand stop-loss and take-profit:
What is a stop-loss order?
Stop-loss orders are instructions to purchase or sell an asset whenever a desirable specified price is reached to limit their losses. As a result, traders may manage their downside risk by restricting their loss.
Once markets go in their direction, they can also protect their profits on an existing winning position by placing a stop-loss order above/below the opening price (depending on the direction of your trade) just in case prices suddenly change direction.
Pros of using stop-loss orders
- It protects the investor from heavy losses
- It promotes discipline and emotionless trading habits
- They’re automatic orders that are easy to implement
- It helps investors to control their risk, especially when they need to monitor multiple investments
- The trader can calculate their desired risk depending on their risk appetite
- It helps the trader feel more in control and confident over his/her trading process
- It is free to implement on most trading platforms
Cons of using stop-loss orders
- They’re not guaranteed to fill at your desired price when volatility is high because of gaps and slippage
- They’re not great for assets that are known for large price swings, so it's important to do your research and look at the normal asset fluctuations
What are the different types of stop-loss orders?
It's worth noting that there are a few different types of stop-loss orders, which vary in usefulness depending on your risk profile and style of trading. You may want to experiment with them all and adjust your strategy as you decide what works best for you. Be also aware that not all brokers offer every kind of stop-loss orders.
Trailing stops
Traders who want to limit their exposure to potential losses by following market movements may do so with the use of a trailing stop loss order. The stop price adjusts upwards or downwards depending on whether or not the asset's price advances in their favour. The stop loss will remain in effect as long as it hasn’t sharply reversed.
Guaranteed stop-loss
When you use a guaranteed stop, as the name suggests, your trade is automatically guaranteed to be closed at the price you choose. This is achieved by eliminating the possibility of slippage, which occurs when the executed price of an order differs from the requested price. With a guaranteed stop in place, your broker is taking on the risk of slippage themselves so that you don't have to, which means that a fee is usually associated with such orders.
Progressive trailing stops (an exclusive tool from ActivTrades)
The progressive trailing stop is a protective order that allows you to better secure your gains by introducing two price levels, or increments, as well as a distance from your stop-loss that automatically changes your order when the markets move in your direction. Because of this, a progressive trailing stop-loss order provides you with the possibility of achieving more profits than a typical stop-loss order would prior to the price moving in the opposite direction of your position.
What is a take-profit order?
This type of order is basically the opposite of the stop-loss. It is an order that stipulates a price threshold at which a winning trade can be automatically closed.
Pros of using take-profit orders
- You can ensure yourself a profit if the price hits your desired price
- It promotes trading discipline
- It is automatic and easy to implement
- It reduces your requirement for monitoring your positions once they’re opened
Cons of using take-profit orders
- They might never be executed
- You might exit out of the position too early if you haven’t set up your orders properly
- It is not the greatest strategy for longer term investors
What should you use stop-loss and take-profit orders for in your trading?
Stop-loss and take-profit orders are a great technique for managing your open holdings while investing in different assets. Through the use of a stop loss order, you may establish your risk tolerance and the maximum amount you are willing to lose on a single transaction. Meanwhile, a take-profit order may be utilised to avoid getting too greedy by locking in gains from price increases or decreases according to your scenario and risk profile.
Keep in mind that the benchmarks you set for your stop-loss and take-profit orders are unique to each trader. They’re not foolproof, and they don't guarantee profitable results. Instead, they serve as a road map for decision-making, hopefully resulting in a more methodical and confident trading process. Therefore, it is a smart trading practice to assess risk by establishing stop-loss and take-profit levels, but also look at it as one strategy among other risk management measures in your toolkit.
How to determine where to set your stop-loss and take profit orders
To determine where to place stops and where to cash in gains, many traders and investors use one or more of these methods rather than relying on just one. These points provide the technical backing they need to get out of a trade, whether it's to cut their losses or cash in on their gains.
You’ll need to refer back to your own trading plan and consider your appetite for risk when deciding how to set up your targets. For instance, you might be comfortable with losing half your investment before pulling your capital, or you may only want to lose 25% as a worst case scenario.
Calculating your risk ratio is as easy as dividing your desired net profit by the price at which your stop loss order will be activated. As an example, if an investor has to put up $1 to get $2 (risk ratio of 1:2), they may not be willing to take the risk. This cautious approach may not appeal to risk-takers, but it is the surest method to see you through the ups and downs of the market.
It's also important with both the stop-loss and take-profit orders to do some research to determine the asset’s background and historical profit potential. Many traders will use technical analysis to identify areas of support or resistance, and will create stop-loss and take-profit orders at comparable levels using historical highs and lows. This way, you’re not potentially closing yourself out of a position prematurely.
You can also rely on chart patterns to decide where to place your stop-loss and take-profit orders, as they also usually provide significant levels monitored by technical analysts.
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