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

Jan 2019
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Stop Loss: What It Is, How to Calculate It and How to Set It Up

Stop loss
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. 

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.

Stop loss
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 will allow you to set this up as a percentage (10% in the above example), while some other trading platforms will let you enter the exact price figure ($180 in the above example).

Stop loss
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 (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 orderIn 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 percentage (of the purhcase 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.

Stop loss
How to decide whether you want to use stop loss at all?

There are many cases when you can and you should use 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. 

  1. Think through where would you feel inconvenient (at what price) and put your stop loss there, but only if you trade.
  2. 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.
  3. 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 they are more volatile.

Stop loss
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% from 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 appetite, the bigger it is the bigger it can be. It doesn’t worth it to use too small (i.e. 0,5%, 1%).

Stop loss
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:

how to manage stop loss

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.

Stop loss
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.

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.

 

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AUTHOR

Gergely Korpos
Gergely Korpos
Co-founder, CPO
Gergely's aim is to bring more clarity into personal investing. He has 10 years of experience in financial markets with GE Money, KPMG and MOL. He concluded thousands of trades as a commodity trader and financial portfolio manager
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