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Stop Losses

What are they - How to use them

Page Summary :

This guide looks at what stop losses are, how they're used, the advantages they carry in limiting losses and therefore preserving capital.

It is important to realise that using stop losses with products like spread bets that offer leverage is critical. To be successful in trading leveraged products you've got to respect potential risk and that's what stop losses are all about.

Note : Although this guide is on the Spread Betting part of the website Stop Losses follow the same principles for all the markets, whether CFDs, Options, Stocks or Futures etc.

As the name suggests a stop loss order is an order designed to limit a loss to a certain level.

It is an integrate part of spread betting, in fact any financial product that uses and offers leverage. For example -

  • You buy the FTSE 100 market at 4230 expecting it to go higher
  • To limit your loss in case the market collapses you enter a stop loss order to sell your position at 4200
  • The stop loss order will only be activated should the FTSE fall below 4200
  • In this example the market does move lower and as it breaches the 4200 level a market sell order is executed at the market price

On the whole, stop losses are easy to understand, just think of them as market orders that are activated only if a certain price is hit - more information on the different types of orders

And because spread betting allows a trader to go either long or short a stop loss can in turn be either a buy or a sell order. For example -

  • You short £2 of the FTSE 100 at 4230 expecting it to move lower
  • You enter the stop loss order of buy £2 at 4250 on a stop loss
  • The order won't be executed if the market doesn't trade higher than 4250
  • But assume it does and so the £2 short FTSE position is covered (bought back) for a loss
Slippage - It's important to understand
Stop losses work in a similar fashion to a market order, but they are held back until a certain price point is breached. A market order, discussed on more details on the orders guide, carries both an advantage and a disadvantage -
  • Advantage - guaranteed fill, if you enter either a market buy order or sell order you'll always trade at some price

  • Disadvantage - the price you deal at might not always be to your liking. Perhaps the market is extremely volatile and prices are jumping around all over the place
An example of this would be the important economic figure that's published every month - US Non-Farm Payrolls (their unemployment figures). These are often hotly anticipated and if a shock number is released markets can go haywire.

The FTSE for example can easily move in a 50 point range in under a minute. It's not always that severe but it has happened many times in the past.

The point is this - a stop loss order only gets activated as it moves through a certain point, and when it does it becomes a market order. And if at the precise time (as it moves through the stop loss level) the market is volatile the price where the actual order is transacted might be different from the original stop loss level. For example -

  • You are long £1 of the FTSE at 4230
  • You put in a stop loss order to sell £1 FTSE at 4200
  • As the market breaches 4200 a market order is activated to sell £1 at the current market price
  • At the same time an unexpected economic report is published and a tsunami of sell orders hit the market at once
  • As there are not enough buyers the price drops immediately to 4190 and that is where your stop loss is filled
  • And this 10 point differential (4200 - 4190) is called slippage and you must understand it
Slippage is a way of life - get used to it

Nobody likes slippage but -

a) you don't always get it and
b) it's not often that bad, perhaps 1-3 points in the FTSE but it does depend on many factors such as -

  • How volatile the market currently is
  • Whether the market is devouring any news, perhaps an economic figure
  • How liquid the current market is, for example the FTSE is very liquid at 4pm, not so liquid at 4am
  • How many other stop losses there are at the same level
If you're new to spread betting don't get worried about potential slippage on your stop loss orders. You cannot be a trader without it - it's a fact of life whether you're the smallest trader in the market or the largest.
OCO orders and Stop Losses
  • You are long £2 of the FTSE at 4230
  • You enter a limit sell order at 4270 combined with a stop loss order at 4210
  • The idea is that you've got both bases covered, if the market rallies you'll sell out at a profit, it if declines the order will be sold via a stop loss
  • So whichever order gets filled the other is automatically cancelled hence OCO (One-Cancels-Other)
A similar OCO order can be used to sell out on the close of business -
  • You're short £5 of the FTSE 100 at 4200 expecting lower prices
  • The market is drifting lower in the afternoon and instead of entering a limit buy order to cover your short you decide to cover it on the close using an MOC (market on close order)
  • But you still want a stop loss in place to cover the trade at 4210 should the market rally
  • The order would therefore be buy £2 of the FTSE at 4210 stop OCO MOC
  • Or in plain English buy £2 of the FTSE on stop at 4210 or on the close whichever happens first
And there's even an order which consists of 3 separate orders -
  1. A limit order
  2. A stop loss order, and
  3. An MOC

For example -

  • You're long £2 of the FTSE at 4230 expecting prices to rally
  • You enter a limit order to sell at 4260 + a stop loss order to sell at 4200 + a market on close order (MOC)
  • The order would therefore be buy £2 FTSE at 4200 OCO 4260 stop OCO MOC
  • Or in plain English buy £2 FTSE at 4200 or 4260 stop loss or on the close whichever happens first
Stop loss orders are not always about taking losses
Finally, a stop loss order can be used to initiate a new position or as discussed in the next heading to protect a profitable trade.

Traders often use momentum to determine whether they should go long or short the market and will then often use stop loss orders to enter into a new position. They use the argument that a market often gathers pace when it starts to move one way or the other.

Their strategy is therefore to go long into strength or go short into weakness and if the market does neither they stay out. For example -

  • The FTSE is trading at 4200 and your analysis suggests if it moves through 4230 it's got a great chance of hitting 4300 but if it stays trading below 4230 you don't want to get involved preferring to sit on the sidelines
  • Your order would then be buy £5 of the FTSE at 4230 stop
  • If the market rises past 4230 the stop loss order will get executed at 4230 + any slippage
  • So although you've used a stop loss order it was to initiate a new long position
Stop loss orders can also be used to protect built up profits

For example, if you bought the FTSE at 3700 and it's now 4200 which is a hell of a lot of open profit.

Who says the market can't rally another 200-300 points? But if it doesn't you place a sell stop loss at 4125 so if the market does decline you've still bagged an excellent return.

In these situations traders will often use what's called a trailing stop loss - see below for more details.

Summary - Some of those orders might be a mouthful but they're easy to understand. They might not click at first but if you take your time you'll soon get on top of everything.

The different types of Stop Loss orders
So now you know what stop losses are and how they're executed where do you place them, ie at what price levels? Sadly, there's no one size fits all answers but here are some ideas.
Money Stop Losses
The simplest stop losses are money stops where a fixed amount of cash is at risk. For example -
  • You go long £5 of the FTSE at 4230
  • You decide to risk £100 on the trade
  • So enter a stop loss order to sell £5 FTSE at 4210 (4230 - 20 = 4210)
Percentage Stop Losses
Percentage stop losses can either be a percent of where the market is currently trading or a percent of your trading capital . For example, if using a percent of where the market currently is -
  • If you go long the FTSE at 4200 and enter a 1% stop loss - that would be at 4158 (4200 x 0.99)
  • If you went short the FTSE at 4200 a 3% stop loss would be at 4326 (4200 x 1.03)

However, as spread bets use leverage even a 1% or 2% move against your current position can result in significant losses. This is an important point.

So when using leverage many traders will prefer to use a percentage of their trading capital, usually in the 1% - 5% range. Assume you're risking 3% for this example -

  • Your account has a balance of £5,000, 3% of that is £150
  • You buy £2 of the FTSE at 4200 and so the stop loss order is placed at 4125 (75 x £2 = £150)
Technical Stops
Personally I like technical stop losses the best. This is where the stop level is placed above or below a certain chart point. Now, you may or may not like charts, but they are useful for gauging market behaviour.

Daily Vodafone Chart

The daily chart above is of Vodafone. The low of the recent move was 112p. The theory is that as 112p found support before probability states the level should find support again.

But the stop loss level shouldn't be at 112p, rather somewhere below this level to give the market some room to move. If it was me placing the stop loss I'd probably put it at 108p-109p.

Basically technical stops have some price relevancy built in, ie they're based on what the market has been doing. This in contrast to pure monetary stops which are placed at arbitrary price levels.

The recent high/low stop loss

As the name suggests these stop losses are placed above or below the recent high or low, perhaps for example yesterday's low or even today's low if you're day trading.

The reasoning behind these stops is similar to Technical Stops above. If a market has found support, ie excess buying at a certain point, then probabilities state it will do so again.

Again, how many points above or below the recent high/low should the stop be placed at?

This depends on many factors such as what the market is, how volatile it's been and possibly any forthcoming news. If it was the FTSE and in normal market conditions then a practical level would be 5-10 points above or below the high/low.

The dangers however of both technical stops and using the recent high/low is that these levels are also where many traders place their stops. This is why sometimes you'll see a market go crazy around one of these price points as many stop losses orders get hit at the same time. In such a case your stop loss might be filled with more slippage than normal.

Longer-term traders can also use recent highs and lows for guidance in stop placement. But instead of using the previous daily low, why not use the low of the previous week or month? This is normally a far better place to put your stop than a fixed percentage or monetary amount because again you're letting the market guide you.

Trailing Stop Losses
A trailing buy stop loss is where the stop level moves higher as the underlying market moves higher. Conversely a trailing sell stop will move lower as the underlying moves lower. For example -
  • If you go long the FTSE at 4200 with a 25 point trailing stop loss, the stop level is 4175
  • If/when the FTSE moves to 4201, the trailing stop also moves up by a point to 4176
  • If/when the FTSE moves to 4210 the trailing stop level moves to 4185 and so on
Trailing stop losses are normally used to protect a profitable position and are hardly ever used to take out a new position.
Breakeven Stop Losses
A breakeven stop is a stop loss order that is placed at the same level as where the original trade was transacted. For example -
  • You buy the FTSE at 4230 and it shoots up to 4250
  • So far it looks like a good trade and you fully expect the market to continue to rise
  • But you don't want a good winning trade to end up losing so you place a stop loss to sell the position at 4230, your original entry price
But you want to try to get some balance on how far the market should move in your favour versus placing a breakeven stop loss. For example, if you buy at 4230 and the market moves to 4235 a breakeven stop of 4230 would have a high chance of being executed. Traders therefore use them when the market has made a reasonable move in their favour, in the FTSE probably at least 20 points if not more.
Tight stop losses versus wide stop losses

This is an argument that has been going on for as long as stop losses have been around, and unfortunately it will never end as there's no right or wrong answer.

The question is this - is it better to use a tight stop loss (one that's near to where the position was opened) or a wide stop loss (one that is far away). An example, assume you bought the FTSE at 4200

  • Tight stop loss level - 4190 (10 points)
  • Wide stop loss level - 4150 (50 points)

Both have good and bad points.

The tight stop loss, at 4190, will lose you the least money but at the same time has a high chance of being hit as it's only 10 points away. The markets obviously never move in a straight line so it's possible you buy the FTSE at 4200, the market drifts lower to 4188 activating your stop loss, before rallying sharply to close at 4275.

The wide stop, at 4150 has far less of a chance of being hit. But if it is, the loss of 50 points will be relatively large. However, if the market sells off (after you've gone long at 4200) to 4185 before rallying sharply to close at 4275 clearly the wide stop was better, with hindsight of course.

Timing has to be considered

So which stop is better, tight or wide? It's hard to answer but on the whole I would think that wider stop losses are better because most traders struggle with their timing. We might for example forecast the FTSE 100 points higher over the next 2 days but in fact it takes 5 days. So with a wider stop loss we give the market more room and time to move.

Clearly though there has to be some balance struck towards how you trade the market.

If you're shooting for small and quick profits then tighter stops are normally better. But if trading weekly or even monthly moves wider stops are generally better. Yes, you'll lose more when wrong but then longer term positions should provide more profit as well.

Summary - When many people start trading spread bets the temptation is to use stop loss levels that are too near to where the current market is trading because they believe the risk is smaller. But they often forget the percentage chance of the stop loss level being hit is high.

One way to confront this problem is to initially use a wide stop when you first enter the market and then move the level as the trade evolves. For example -

  • You go long the FTSE at 4200 with a view to holding the position for a few days thinking there's at least 100 points of profit available
  • Place your initial stop loss at 4150
  • Then, later in the day as you get a better feel for how the market is trading move the stop level higher
  • And with online trading this is as simple as a few mouse clicks
Experience is Important when Placing Stops

This guide has shown there is no exact science when figuring out the level to place a stop loss. Sometimes many factors come into play and experience is often the key when deciding the right level to place them. Perversely you will find that you learn a fair amount by putting your stops in the wrong place.

While this is not good news in the short term it's often good news over the long run. Learning from your mistakes, assuming you do learn from them, is the best education a trader can receive.

The main error people make when first using stops is to place them too near to where the market is trading. If you want to cut down on the number of errors that you make when you start out, then try to place your stops far away from the current market price, giving the market plenty of room to naturally move around without stopping you out.

LearnMoney comment:
The real goal of the stop loss is to prevent you losing a significant amount of your capital (5% - 10%+) on any one trade. Remember, as spread bets use leverage even a small move in the underlying can translate into large profits or losses.

Yes, stops will often frustrate you, they frustrate all traders and yes, you'll sometimes place them in the wrong place. But if you use stops when trading spread bets it will mean you have a good understanding of trading and how to approach the game.

So many new traders think spread betting or speculation in general is all about reward whereas it's about first controlling your risk and risk cannot be controlled without knowing where you're going to take any potential losses.

So if you use stops it means you've addressed the risk problem first, ie how much can I afford to lose on this position. This is how professionals trade and how they can survive year after year. In effect they worry about potential losses and let the profits take care of themselves.

So work hard at your stops, where to place them and how to build them into your own trading, and ignore this statement at your peril -

"More money has been lost in the markets by people not using stops than all the other reasons put together"

WARNING! - Spread Bet Broker Advice

There are good spread bet brokers and there are bad ones.

Having a good broker won't guarantee you profits but a bad broker will probably lead to losses as a combination of their gamesmanship and suspect software takes its financial toll.

So who do I recommend?

Simple, the 2 brokers I personally use for my own spread betting (and I've used them for years) -

FREE Report : How to Learn Spread Betting and Prosper
How to build the all-important trading experience
Where to get trading help and advice
Which broker to use and why
Simple 2 month training plan to follow
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