Using Stop Losses
In contrast to a limit order, a stop order is an instruction to trade when the market hits a level less favourable than the current price.
Why would you want to trade at a worse price? Well, perhaps the most important reason is to close a position that’s moving against you. To do this, you attach a stop order to the trade. Then, at the point beyond which the level of loss would be unacceptable to you, your stop will pull the plug and close out the position.
As we’ll explain in the next lesson, when markets are moving very fast it may not be possible to close the position until the price has already passed the level you set, but certainly the stop will give you some protection against escalating losses.
Because it helps restrict your losses, this type of stop order is known as a ‘stop-loss’. Here’s how it works:
Example
Let’s say you own 100 shares of ABC inc which you bought at $37, and now the price has declined to $35.
You hope this is just a temporary move, but you decide if the price should fall as far as $32 it will be time to cut your losses. You place a stop-loss at $32.
Unfortunately, the price keeps sliding all the way to $27. However, your stop-loss is triggered at $32 and your position is closed.
You’ve lost $500 (100 x $5), but without your stop-loss you would have been looking at a $1000+ loss.
You can also use a stop order to open a new position – known as a stop entry order.
Placing an order to open a trade at a worse price than the current price might seem very strange, but sometimes it can make good sense.
For example, analysis might suggest that if a market hits a certain level it will carry on moving in the same direction. By setting a stop order at such a level, you would be ready to open a position and potentially take advantage of this momentum.
Trailing Stops
A trailing stop is a special type of stop-loss – it not only caps losses, but also helps protect any profits you make.
Like other stop-losses, a trailing stop is attached to a trade. If the market price moves in your favour by a specified amount (known as a ‘step’), the trailing stop copies this movement. So it keeps its distance from the current price, but step-by-step it gets closer to the price at which you opened your trade, and may pass it if the favourable movement continues.
However, if the market then turns against you, the trailing stop stays put. This means it can close your position at a more favourable level than a standard, stationary stop-loss would have done – potentially while you’re still in profit.
Example
Suppose you decide to go short on USD/JPY at 117.60. You set a trailing stop 30 pips away, at 117.90. You choose a step size of ten pips.
The market initially drops five pips. As this is less than the step size, your stop stays at 117.90. The price then drops a further five pips to 117.50, triggering your stop to move down to 117.80.
A little later, USD/JPY has sunk to 117.10. Your stop has followed it, and is at 117.40. However, now the market trend reverses and the price rises to 117.50. Your stop remains at 117.40, so your position is closed as the price passes through this level.
The stop has protected a profit of 20 pips for you. However, it’s worth noting that if the market’s upward movement turns out to be temporary, you may have missed an opportunity for greater profit by closing the position now.
As with other stop-losses, a trailing stop doesn’t guarantee that your position will be closed at exactly the level you set. Later in this course we’ll explain how you can protect yourself further against loss by using guaranteed stops.