One of the most important tools investors have to limit their losses and take your profit on the stock market are stop loss and take profit. These are the parameters that you can set in your broker to prevent a sharp drop in the value of a share from having negative consequences on your investment portfolio.
What is stop loss and what is it for?
A stop loss order is a type of conditional order that executes the sale of a certain asset if its price falls below the marked limit. A trader sets this price level in his trading account, thus establishing the maximum level of loss that he or she is willing to assume.
Thanks to these limits we cut the possibility of suffering further losses if the stock continues to decline, although we also lose the possibility of benefiting from the rises if the stock subsequently recovers.
Where to place Stop Loss
Today, almost any broker offers the possibility of setting stop loss easily and quickly. And although there are different strategies to calculate where to place them, there is a very simple universal rule to apply: calculate the maximum percentage of losses that you are willing to assume for your investment.
For example, if the current price of a share is $10, and the maximum percentage of loss that you are willing to take is 10%, so you will put stop loss at $9. Thus, if the share price falls below this level, the sale will be executed automatically, thus avoiding having to assume large losses for the investment.
The snowball effect of stop losses
The main criticism made of stop losses is that they are executed too frequently, especially if the level of losses assumed by investors is very small compared to the current price of the share.
In these cases, a bad one-off market day can trigger the massive sale of these securities, causing their price to drop even further and in turn activating the sales orders that were below that level.
In the end, there is a snowball effect of losses that are not supported by the fundamentals of a company. Therefore, many times the value recovers quite quickly and those who have given these orders can lose a good revaluation.
Types of stop loss on the stock market
There are at least three types of stop loss orders offered by brokers, each with different characteristics:
It is the most common stop loss order. In this modality, the investor establishes the potential price at which the transaction will close and, when this price is reached, the sale takes place. The order remains unchanged from the moment it is posted, unless the investor modifies it manually.
Keep in mind that the standard stop loss is set on a specific price and is only executed if it reaches exactly that level. However, sometimes this price is exceeded by the market dynamics itself. This circumstance is known as slippage , and it can cause the investor to lose more than he had anticipated.
For example, if you have set a stop loss at $9.90 for a stock that is trading at $10 and its price falls directly to $9.80, the broker will execute the order with this last price, and not at the price set by the stop loss.
The guaranteed stop loss works in a similar way to the standard, with the only difference that it will be executed only at the fixed price, and only at that price. That is, it is not subject to slippage.
The broker agrees to close the transaction at the exact price and assumes the risks and losses associated with volatility . However, for this, you can ask for additional guarantees or commissions.
The trailing stop loss is not set at a specific price, but is relative to the current share price. The investor sets the number of points below which the stop loss is triggered . If the price of the stock moves up, it moves with it, in such a way that it is always at the distance set by the investor. However, if you move in the opposite direction, the order remains unchanged.
For example, imagine that for a stock that is currently trading at $10, you set a trailing stop loss 20% below market price. Initially, the sell order is set at $8. If the stock rises to $12, for example, the sell order will be set at $ 9.60. However, if it drops to $9, it will remain at $8. In this way, you protect yourself against excessive losses while ensuring part of your profits.
When to place a stop loss when investing in the stock market
When you place a stop loss when investing in the stock market, you are protecting yourself against abrupt falls in the markets and guaranteeing a maximum percentage of loss in each operation.
Therefore, when setting it, it is advisable to think about the potential loss that you are willing to assume and act accordingly, placing the stop loss at the level with which you are most comfortable in each market situation.
What is Take Profit?
Take Profit is a command sent to a broker through a trading platform to close the open position at a certain level with a profit. The order is executed only if the price touches the determined level. In addition, the order is activated automatically.
Take Profit is a command sent to a broker through a trading platform to close the open position at a certain level with a profit.
It is worth mentioning that some experts provide various take profit points by providing trading recommendations. It means that you can place more than one take profit level if the trade continues to move in your favor.
Furthermore, take profit orders are acceptable for any security, not only for currencies but also for stocks.
Why should you use Take Profit?
Although some traders forget to place take profit orders, we recommend using them. Take profit orders are more efficient for long-term trading.
Let us consider an example. Imagine that you opened a long position on the EUR / USD pair on August 1 (1) and you plan to hold it for several days. As you can see from the chart, from August 5 (2), the price started to consolidate and then declined, as you were trading on the swing of the downtrend.
If you placed the take profit order at 1.12, where the trend line is located or at 1.1237, where resistance could be established, according to the two previous points where the pair recovered, you would save your possible profit and exit the market before a bounce.
If you do not place the take profit order, there is a high risk that you will lose everything you won. In short, a take profit order allows you to minimize the risks of losing money.
It seems that the take profit order is a perfect way to exit the market. But why aren’t some investors using it? Let’s consider its advantages and disadvantages.
Tips for traders
- If you tend to be influenced by your emotions, a Stop Loss/Take Profit strategy will be helpful and will prevent you from changing your mind or doubting your strategy. After you have done a good risk/reward calculation regarding taking a position, you can establish a stable and reliable strategy that the stop loss and take profit orders will guarantee that you will follow. These types of orders will allow you to maintain your initial strategy while following market elements that could affect you.
- Although the take profit level can be modified once the position is open, we also advise you to be consistent and not change your target unless reliable data suggests doing so or in the event of an unexpected event in the market
- The level to which your take profit will move will have to be calculated reliably with methods based on a good technical analysis of the traded value.
- You can also use the price alert systems when you have placed the order to avoid having to follow the charts in real time. You can place these alerts however you like.
- Finally, do not forget to do several tests and different attempts using take profit at different levels. With all this, you will have no problems in finding the optimal profit taking level according to the traded asset
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