What is a stop-loss order
A stop-loss order means that you give instructions via your trading platform that the system should automatically sell your asset when the price drops to or below a pre-specified level. At short positions (when you gain profit from price decrease), the stop-loss is triggered when the price increases at a pre-specified level.
The pre-specified level can be a price or a percentage figure. If it’s a price figure then it’s the price you want your stop loss to be executed. If it’s a percentage figure then it comes from the percentage value of your buying/selling price.
Let's see a quick example for this. You bought a Netflix share for $200 and you'd like to avoid loosing more than 10% of this. 10% of $200 is $20. You subtract this from your purchase price of $200 which is $180. This means you need to sell your Netflix share if the price hits $180. This is going to be your stop-loss price.
What is the trigger price in a stop-loss order?
The trigger price is the price level where you want your stop loss to be executed. It is also called the stop-loss price, usually calculated as the percentage of your buying/selling price.
Some trading platforms allow you to set this up as a percentage (10% in the above example), while some other trading platforms allow you enter the exact price figure ($180 in the above example).
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What is the difference between stop-loss and stop-limit?
Imagine you bought Netflix stock again for $200. When you set up a stop-loss order for $180 (the stop price), this is what you tell your broker in human words: "sell this thing if you see that anyone traded with it at $180".
How is stop-limit different?
In essence, this is a combination of a stop-loss order and a limit order. In human words, it's saying "sell this thing if you see that anyone traded with it at $180, but don't sell it lower than $160".
Both stop-loss and stop-limit can be set as a percentage (of the purchase price) and as an exact price. This is dependent on the broker, there is no standard for this. Brokerages catering for professional investors or traders usually let you set exact prices.
How to decide whether you want to use stop-loss at all?
There are many cases when you can and you should use a stop-loss order. But how do you know if this is the moment you should use it? Keep in mind the original purpose of it: to save you from big losses.
- Think through where you would feel inconvenient (at what price) and put your stop loss there.
- As a rule of thumb, use it if you are actually trading and if you are not a long-term investor. This is a trading tool. Long-term investors don’t use stop-loss because in the long run short-term volatility doesn’t bother them and they make their buy/sell decisions slower.
- It’s also dependent on the asset class you are dealing with (i.e. forex, share). A small stop-loss can be more easily triggered by shares than by bonds because shares are more volatile.
Tim Fries, the co-founder of The Tokenist, a trusted gateway into the world of fintech and blockchain technology, and the founder of private equity firm Protective Technologies Capital tells us about his reading on how to use the stop-loss order.
"Traders, particularly leveraged ones who are either using margin (borrowed) capital or derivative instruments like options and futures, are best advised to use stop-loss orders all the time. This is because such traders are subject to magnified losses should the market move in an unexpected direction.
On the other hand, depending on their trading strategy and experience, some investors can opt to skip stop-loss. This best applies to investors that have done their research on a particular security, and believe they are buying it below its intrinsic value.
Meanwhile, long-term investors who do not intend to exit positions any time soon might find it best to avoid stop-loss altogether. This is because stop-loss orders can be triggered as part of a brief bounce when an asset plunges temporarily only to subsequently increase. Again, whether or not stop-loss orders should be used, all comes down to investor experience and strategy.”
Tim Fried from Quant Investing tells us how he approaches the stop-loss order:
"I never enter a stop loss on my broker platform. I track it in my portfolio spreadsheet. I do not want to get stopped out of a position due to market volatility”.
And on how often did he experience that the price jumped over his stop-loss?
"That happens sometimes but usually only if there are extreme events such as s profit warning or fraud for example. Most of the time a company recovers above the stop loss inside the month that I look at the stop loss,” he told us.
How to calculate?
Imagine you bought an Apple share for $140 and you want to set up a 10% stop-loss. 10% here means that you do not want to lose more than 10% of your invested money ($140). 10% of $140 is $14, so you do not want to lose more than 14 dollars.
This means that you have to sell your Apple share at $126 (=140-14) if the share price starts to fall.
How much you should set up? It’s based on your risk preferences and strategy. risks you can bear it is the bigger it can be. It doesn’t worth it to use too small (i.e. 0,5%, 1%).
Tim tells us the following about his experience:
"The best stop-loss level is one that perfectly restrains the cumulative number of dollars at risk to the smallest portion possible while giving the trade enough room to survive transitory bounces. In other words, a stop-loss should be activated when the market moves opposite to the predicted direction to prevent extended losses.
Generally, stop-loss should be placed to limit the total capital at risk to lower than 2% of a trader's account balance, and preferably below 1%. It is worth noting that traders need to take into account their strategy to be able to place an appropriate stop-loss order."
How to set up?
Setting up a stop loss means that you insert an order via your trading platform after you bought the share (or at the same time). Here you define that if the share price of Apple touches $126, you want to sell it. The system will execute the transaction automatically, so you do not need to check the share price every five minutes.
On Saxo Bank’s platform:
You can set it up while you are purchasing or anytime later. As a rule of thumb, it’s best if you think ahead and set it up right when you purchase it.
Can a stop-loss fail?
Yes, in case of price drops too much. Setting a stop loss is not a guarantee, it’s just a trigger you let your broker know that you want to sell it on the given price. Brokers don’t sign a guarantee for the execution of the stop loss.
Good to know
If the market falls, there is no guarantee that the system can sell the share at the specified stop-loss price (in the prior example 126), since the $126 price triggers the execution but the price in the next second can already be lower. So if you want to have a higher chance of not losing more than 10%, you should insert the stop loss price a bit above your desired selling price. I.e. if you wish to sell at 126, then insert 126,1.
Can market makers see stop-loss order?
Your broker can be the market maker as well (ie. in case of CFD brokers) and in that case, they can definitely see your stop loss. Sometimes brokers sell this information to high-frequency traders.
Can other traders see stop-loss?
No. You can see other trader’s stop-loss neither on the same exchange nor across exchanges.
Should long term investors use stop-loss order?
Long term investors usually don’t use stop-loss because they are less affected in short term price changes.