Let’s be honest, the only reason you trade is to make a profit. However, losses are inevitable, especially if you are trading in a volatile market.
But what if there is a way to reduce these risks?
In fact, it is one of the most common risk management techniques to limit potential losses. So, in general, this is the type of order used by traders to exit a position when the price goes against them until it touches a given level. When the price crosses this level, the trading platform automatically closes the position to avoid further losses.
What is a stop loss order?
Stop loss is a universal risk management method applicable in stock trading and even crypto trading to effectively limit potential losses. It gives traders the flexibility to trade with confidence. In most cases, traders use this order type to set a specific price level at which an existing order will automatically close if the price touches it.
Technically, a stop loss is a conditional instruction that a trader gives to a cryptocurrency exchange. When the price of a cryptocurrency touches a given level, the order is automatically converted into a market order, which is executed at the next available price. A stop loss can be set at any price level and can instruct a crypto exchange to buy or sell a cryptocurrency, depending on the nature of the existing position.
As you can see, we have a candlestick pattern called Shooting Star that usually appears at the top of an uptrend and heralds a bearish reversal.
Let’s say you decide to open a short position and want to place an order to sell bitcoin. However, you are not sure if the price will move in accordance with your expectations – no trading pattern can guarantee us that the price will move in one direction or another. Therefore, we place a stop loss just above the Shooting Star candle if the price continues to move bullish.
Presumably this happens, the stop order is triggered, and we end up with a loss. However, at least the losses are limited, which helps us to control the situation. Luckily, the price shown in the above example continued to decline as planned and the stop loss didn’t work at all.
Ultimately, stop loss orders are meant to help you save time, along with a take profit order. The latter is launched when you exit a profitable position.
Let’s say you use these orders. You can give up the grueling practice of regularly monitoring your positions. Stop orders are ideal for short-term traders who need to automate much of their trading process. If you are a swing trader holding several open positions for several weeks, you may not even need a stop loss as long as you check prices daily. However, using stop loss is very simple and you have nothing to lose by setting them.
How to use a stop loss order correctly?
The main purpose of a stop loss is to limit potential losses. However, simply placing a sell stop loss below the market price will not necessarily protect your long positions, and vice versa.
To achieve the maximum effect, you must learn how to use the stop loss correctly. Everything depends on the situation. However, as a general rule, you would be interested in setting a stop loss near previous support or resistance levels. For example, you should place a sell stop loss just below a previous support level, whether it’s an uptrend or a horizontal channel.
Stop Loss vs Stop Limit
Stop loss and stop limit orders are similar because their purpose is to protect open positions.
However, the difference between them shows up when the price hits the stop. In the event of a stop loss, when this occurs, the position is automatically closed. The bad news is that the position may not necessarily close at the price specified in the stop loss, which can happen during sudden crashes or gaps.
Thus, in the case of a stop limit order, when the price touches the stop, only the limit order is triggered, which is executed only if the price touches the limit price.
A stop limit gives traders more control over their positions relative to the prices that trigger an exit from the market. However, stop losses are easier to use and can limit losses.
Benefits and risks of using stop loss and stop limit orders
They both work for you and minimize our potential losses.But did you know that another great thing is that they help you automate your trading process? In fact, it is useful to allow you to focus on other tasks or market analysis to find new opportunities. It is indeed a great relief to know that day trading doesn’t have to be so stressful.
However, the disadvantage is that even if you use either of the two orders, this does not mean that you are 100% protected from large losses. Stop loss may not work correctly during flash crashes and price gaps, leaving you with bigger losses than expected. In contrast, a stop-limit order may not be executed at all if the price does not touch the limit price. Hence, it would be helpful if you could still keep an eye on them even if everything is automated.
As a reminder, stop-losses and stop-limit orders are excellent methods of minimizing losses in case the price moves against you. As wise people say, “practice makes us better,” and trading is no exception. Hence, you should try to make as many mistakes as possible on your demo account before diving into real trading. Make sure you understand how it all works and choose one of the orders as your primary risk management method.