Why Use Stop Loss Orders?

Published by Filipe R. Costa on Tue, 22/03/2011 - 10:11
stop loss order

Financial spread betting has several advantages over traditional trading: you don’t pay broker commissions and stamp duty, there is no capital gains tax due, it is easier to access markets, and it is possible to make huge profits with small investments. But at the same time, the leverage you get from margin trading triggers some challenges in terms of money management.

Spread betting can easily be a tachycardiac activity when money is not very well managed, even if you have a sound trading strategy. You can implement 300 excellent trades and in a single one impair all your previous gains and maybe some extra funds. There are several situations that can lead to that route and you should be well aware of that beforehand and implement some protection. The best insurance available for a spread trader is called stop loss order.

A stop loss order is a way of limiting any possible losses and to give you a clear picture on how much you can lose if things go wrong. You may well close several positions with a £50 profit and suddenly have just one still opened that starts to lose in a fast market movement that puts you in a £500 loss. You could well have avoided that by using a stop loss.

A stop loss is a limit order that is executed when a certain level is reached. It is intended to limit losses so it is set at a lower price than your buy price or at a higher price than your sell price (when you are short in a position). Some slippage can occur when markets go up or down very quickly, but some slippage is always better than a blustering accident.

Many times you will be tempted to change your stop loss when the market moves against you, to avoid being stopped and keep your position opened. Avoid that at all costs. You will change the stop one time, and probably a second time. It’s possible that the market continues moving against you, and you will then change the stop level again until you decide to withdraw it completely. The wisest thing to do is to just keep your stop loss, let your position be closed automatically, take the loss, assume you were wrong on that trade, and look elsewhere for more opportunities to enter the market again.

In certain occasions it will be desirable to relax a stop loss but as a rule of thumb you shouldn’t do that.

When the market goes in your favour you can change the stop order in order to trail the market movement. The situation here is very different from the unfavourable movement we have seen above. You are winning with your position and no longer want to have your stop at a level that will guarantee a small loss. You now want to guarantee a profit because you have margin for that due to the favourable market movement. In this situation you will push your stop level closer to the market price. Another rule of thumb here is that a changed stop never goes back. If the market suddenly turns against you just take the profit instead of returning back to the beginning.

The level for the stop loss should be set by you when you are planning the trade and not after executing it. The exact level can come from you research, from technical analysis or just from some predefined maximum loss you set as rule. You should always take into consideration two simple rules:

  • Don’t risk more than a certain percentage of your funds in a single trade
  • Look at the volatility faced by the instrument you are trading. 

A stop loss set at a level that corresponds to a maximum loss of 50% of your total funds is not reasonable. By other side, a stop that is just 3 points behind the FTSE 100 will most certainly not give you any margin for the normal volatility the index experiences, and thus is also not reasonably set.

Summarising what was said, for the sake of preserving your funds and being successful at financial spread betting, use stop loss orders every time, and keep them stick unless it is to trail a gain.