Understanding stop-loss orders, with examples

Stop-loss orders are an essential tool for managing your trading risk better.

Opening a trade without a stop-loss order is like driving at high speed without a seat belt. In the event of a crash, the consequences could be disastrous!

Using practical examples, you will learn how to properly place stop-loss orders based on your trading strategy, market conditions, and risk management rules.

WARNING

Trading exposes you to the risk of losing more than your initial investment and incurring financial liability. Trading is suitable only for well-informed, sophisticated clients able to understand how the products being traded work and having the financial ability to bear the aforementioned risk.

Transactions involving foreign exchange instruments (FOREX) and contracts for difference (CFD) are highly speculative and extremely complex. As such, they are subject to a high level of risk due to leverage. Please keep in mind that CFD trading is banned in the US.

Information published on the NewTrading.io website is for informational purposes only and should not be construed as offering investment advice or as an enticement to trade financial instruments.

What are stop-loss orders?

Stop-loss orders are stock market orders that close an open position in order to contain an investor’s losses as prices move against them.

From a technical perspective, a stop loss order is an order that automatically closes an open position by executing an order of the same size in the opposite direction when a certain price level is reached.

How do stop-loss orders work?

Stop-loss orders are tied to a key price level set by the investor: the trigger price. When that price is reached, the stop-loss order automatically becomes a market order and the positions are liquidated immediately, whatever the price.

When stop-loss orders are triggered, they are executed at the first available counterparty’s price. In other words, when a sell stop-loss is triggered, it is executed at the best buyers’ price offered at a specific time, and when a buy stop-loss is triggered, it is executed at the best sellers’ price offered at a specific time.

The different types of stop-loss orders

Beyond traditional stop-loss orders, there are several types of stop orders that provide specific guarantees or options. They include limited stops, guaranteed stops, trailing stops, etc.

Limited stop-loss orders

When limited stop-loss orders are triggered, they become limited orders, not market orders.

The addition of a limit allows better control of the execution price by specifying the least acceptable price in the event the stop is triggered. However, there’s a risk of non-execution if no counterparty is available before the limit is reached.

Noteworthy 

If the limited stop-loss order is triggered but no available counterparty can be found before the limit is reached, the position will not be closed, and the trader’s losses will continue to increase. Therefore, this type of stop-loss order should be used with the utmost caution.

Trailing stop-loss orders

Trailing stop-loss orders are stop-loss orders with a variable, not fixed, trigger price. 

Depending on predefined conditions, the trigger price of the stop order gradually gets closer as prices move in favor of the trader in order to reduce the risk of loss (or even protect part of their latent gains).

On the other hand, when prices move against the position, the trigger price remains unchanged so as not to increase the maximum acceptable loss, or give up a portion of the latent gains that have already been secured.

Guaranteed stop-loss orders

Guaranteed stop-loss orders ensure execution exactly at the trigger price, regardless of market conditions. This removes the risk of slippage, so the trader can then sleep soundly at night.

Your financial intermediary might also offer guaranteed stop-loss orders as an option. This insurance carries an additional cost, which is usually charged only if the stop is triggered.

Guaranteed stop-loss orders allow you to manage your risk better. You know your maximum loss ahead of the game and will avoid the debt risk inherent in using leverage.

Under certain market conditions arising from price gaps, stop-loss orders may actually be executed at a price that is significantly lower than the trigger price. 

Due to this “risk of slippage,” it is common to see sell stop-loss orders executed at prices lower than the trigger price or, conversely, buy stop-loss orders executed at higher than the trigger price.

Where should you place your stop-loss order?

Stop-loss orders must be placed at the invalidation price level calculated in your trading scenario, i.e. the price that, if reached, will indicate that your analysis was incorrect.

Therefore, a sell stop-loss order (intended to close a buyer position) is generally placed under a support level, while a buy stop-loss order (intended to close a seller position) is generally placed under a resistance level.

To avoid inadvertently triggering stop-loss orders by market noise, traders generally do not place their trigger price right next to their invalidation price.

As a result, traders must choose between a large and, therefore, safe margin and one that is smaller and less safe. The former would reduce the risk of undesired triggering but increase the potential loss because you’ve moved the trigger price further from the entry price. The latter would increase the risk of triggering but reduce the potential loss because the trigger price is closer.

Noteworthy 

The stop loss is not set in relation to the value of the potential loss but according to the scenario forecast by the trader. The amount of the potential loss is then adjusted in a second step by reducing the size of the position, if necessary.

Know the potential loss associated with your stop-loss

The best brokers usually indicate the potential loss tied to a stop-loss right on their trading interfaces. 

If you calculate the difference between the entry price, and the trigger price, you will arrive at the potential loss associated with your stop-loss for one share. Then multiply that by the number of shares you hold.

For example, suppose you bought 2 units of a Dow Jones E-Mini future at 39,500 points with a guaranteed stop-loss order placed at 39,400 points. The distance between your entry price and the trigger price is, therefore, 100 points.

The point value of the Dow Jones E-Mini future is $5. Your potential loss in the event of triggering the stop-loss is therefore 100 x $5 per point x 2 units = $1,000.

Why should you place a stop-loss order?

Just like when an electrical circuit is overloaded, and a circuit breaker cuts the electrical current to avoid damage, stop-loss orders cut traders’ losses and prevent the situation from escalating, thus limiting the damage.

By placing a guaranteed stop-loss order, you know in advance what your maximum loss might be. This will improve your money management rules and the quality of your trading measured by indicators such as the profit factor or the maximum drawdown.

By using stop-loss orders in margin trading, you can reduce the amount your broker locks in (maintenance margin) to cover your risk. This will reduce financing costs for the position.

But why not manually close your positions when you reach your trading scenario’s invalidation level? While this is a viable option, it has several drawbacks.

Without stop-loss orders, traders would have to be monitoring price movements on their computers all the time in order to manually close their position. This would require discipline and a high level of responsiveness. In addition, you’d have to deal with all sorts of pitfalls that might prevent you from manually closing your position, such as a power failure, dead battery, other computer issues, or the internet being down, to name a few.

Should you systematically place stop-loss orders?

While it is strongly advised in margin trading, stop-loss orders can be disregarded in spot trading.

However, you should carefully consider this decision and make it part of your trading plan. What would happen if the value of your security suddenly fell to zero? Would this loss be acceptable? Sometimes it’s better to take a small loss and live to fight another day.

How to place stop-loss orders

Stop-loss orders are usually placed at the same time you open a position, but they can also be placed afterward. The best trading platforms show your stop order right on the chart on your computer screen.

How to modify stop-loss orders

Most trading platforms allow you to change the level of stop-loss tied to a current position. 

Bringing your stop-loss order closer to your position may help to reduce your risk and/or secure some of your latent earnings. On the other hand, be careful about moving your stop-loss further away. Such a move is not to be taken lightly.

How to cancel stop-loss orders

If the stop-loss order was initially created when the position was opened, it is usually canceled automatically when the position is closed manually or when the take-profit level is reached.

You can cancel stop-loss orders for outstanding positions at any time, as long as you have sufficient funds to assume the financial risk of your position. 

However, you should never cancel stop-loss orders while in the throes of emotion; no one takes their seat belt off as the car veers off the road.

Stop-loss orders are an essential risk management tool. To avoid mistakes when placing and modifying stop orders, you should take whatever time is necessary to practice on a trading simulator.