A stop-loss is a crucial tool for traders to manage and preserve their capital. It is a limit that you set on your trade to protect yourself from losing too much money. When the market moves against your position, your stop-loss will automatically sell (or buy) to limit your losses. In this blog post, we will discuss what a stop-loss is and why you should use one in your trading strategy!
What is a Stop-Loss in Trading?
A stop-loss is an order that you place with your broker to automatically close a trade when the market moves against you by a certain amount. The market can respond quickly to geopolitical news, economic releases, and lots of other factors. Sometimes, you’re just on the wrong side of a trade and a stop-loss helps mitigate that risk. It’s essentially an insurance policy that allows you to limit potential losses if the market goes against your position.
See below for an example. Let’s say that you bought EUR/USD at 1.2160 and placed a stop-loss of 1.2090. If the market moves beyond that level, your trade will be automatically closed to limit your losses.
And you live to fight another day… You’ve cut your losses and eliminated the anxiety of trading without a plan, throwing caution to the wind. The stop-loss serves as the invalidation point of your trade idea.
Why Use a Stop?
Having a stop-loss in place is important for any trader. The volatile nature of the markets means that they can move quickly and unexpectedly. By placing a stop-loss, you are protecting yourself from large losses should the market turn against your position.
Let’s look at an example of two traders and how their stop-losses can affect their accounts.
Trader #1 always places their stop-loss very far away from the open price — at a spot that represents 10% of their account balance.
Trader #2 always places their stop-loss tighter to the open price — at a spot that represents 2% of their account balance.
If both traders go on a losing streak and lose ten trades in a row… Trader #2 is down 20%. Trader #1 has blown their account and is out of the game.
The moral of the story is that a reasonably-placed stop-loss helps lower the risk of blowing your account and protects your capital.
Stop-losses also help to keep emotion out of trading decisions. If a trade doesn’t work out, it’s much easier to accept the loss if you have a pre-determined limit in place rather than trying to stay in the trade and hope for a turnaround.
Stay tuned for more on the four types of stop-loss methods to choose from: percentage stop, volatility stop, chart stop, and time stop.
Disclaimer: All information provided here is intended solely for study purposes related to trading financial markets and does not serve in any way as a specific investment recommendation, business recommendation, investment opportunity, analysis, or similar general recommendation regarding the trading of investment instruments. The content, in its entirety or parts, is the sole opinion of SurgeTrader and is intended for educational purposes only. The historical results and/or track record does not imply that the same progress is replicable and does not guarantee profits or future profitable trading records or any promises whatsoever. Trading in financial markets is a high-risk activity and it is advised not to risk more than one can afford to lose.