Stop-Loss: What Is It, How to Calculate It, How to Set It Up

A stop-loss order is essentially an instruction on your trading platform that the system should automatically sell your asset when the price drops to or below a pre-specified level. With short positions (when you gain profit from price decrease), the stop-loss is triggered when the price increases to a pre-specified level.

The pre-specified level can be either an exact number or a percentage. In other words, you can specify either the price at which you want your stop loss to be executed/position closed or a percentage calculated from the purchase price.

Let's see a quick example. You bought a Netflix share for $200 and you'd like to avoid losing more than 10%. In this particular case, the 10% is $20. You subtract this from your purchase price of $200, so you get $180. This means you need to sell your Netflix share if the price hits $180. This is going to be your stop-loss price.

The trigger price is the price where you want your stop-loss to be executed. It is also called the stop-loss price, usually calculated as a percentage of your purchase price.

Some trading platforms allow you to set up your trigger price as a percentage (10% in the above example), while some other trading platforms allow you enter the exact price ($180 in the above example).

Staying with the above example, let's assume you bought Netflix stock 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 it at $180."

How is stop-limit different?

In essence, a stop-limit order is a combination of a stop-loss order and a limit order. In human words, it's like saying "sell this thing if you see that anyone traded it at $180, but don't sell it for less than $160."

Both stop-loss and stop-limit orders can be set as a percentage (of the purchase price) and as an exact price. This depends on the broker, there is no standard for this. Brokerages catering to professional investors or traders usually let you set exact prices.

There are many instance in which you can and you should use a stop-loss order. How can you decide whether the moment is right to set up a stop-loss order? Keep in mind the original purpose of it: to save yourself from catastrophic losses. 

1. Think through where you would feel inconvenient (at what price) and put your stop loss there.
2. As a rule of thumb, use it if you are a trader and not a long-term investor. This is a trading tool. Long-term investors typically don’t use stop-loss because short-term volatility doesn’t bother them and they make their buy/sell decisions over a longer time span.
3. The asset class you trade (i.e. forex, share) is also important. 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 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 du Toit 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. 

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. 

Following this logic, you will have to sell your Apple share at $126 (140-14) once the share price starts to fall. 

How much leeway should you leave? It really depends on your risk preferences and strategy.  It's not worth it to use a small stop-loss (i.e. 0,5%, 1%).

Tim Fried from Quant Investing 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."

You can set up a stop-loss order when you open the position on your trading platform but you can add a stop-loss to an already existing trade. All you need to do is define that once the share price of Apple touches $126, you want to sell it. The system will execute the transaction automatically, you do not need to check the share price every five minutes. 

On Saxo Bank’s platform:

As a rule of thumb, it’s best to think ahead and set it up when you purchase the shares.

Yes, if the price drops too much. Setting a stop-loss is not a guarantee, it’s just a trigger to let your broker know that you want to sell your assets at the given price. Brokers don’t sign a guarantee for the execution of the stop-loss.

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). 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't see other traders' stop-loss either.

Should long-term investors use stop-loss orders?
Long-term investors usually don’t use stop-loss because they are less affected by short-term price changes.

 

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