Presentation and definition of the stop loss order :
First of all, let's take a moment to introduce you to the stop loss order. This type of order allows you to automatically buy or sell a stock when it reaches a pre-determined price level.
As the name suggests, the main purpose of a stop loss order is to cut your losses and therefore limit them, if the price of the asset on which you have taken a position does not move in a favourable direction. For example, if you place a stop loss order 10% below the value at which you have taken a position, it will automatically close the position and limit your losses to this 10%.
The stop loss order is often combined with a "take profit" order, which works in the same way, but this time its purpose is to close the position as soon as a certain target is reached so that you can take your profits before the trend reverses.
What are the main advantages and disadvantages of stop loss orders?
The stop loss order has many advantages for the trader, the main one being that it exempts you from having to constantly monitor the price of the asset being traded. Thus, if you place this order at the beginning of the session, you can go about your business for the rest of the day without fearing that an unfavourable trend will make you lose a lot of money.
Another great thing about stop loss orders is that they are free to use. It is a kind of insurance that you can use at no extra cost. Indeed, it will not cost you more to use this stop loss which will close your position automatically than to use a manually executed order.
Finally, the last advantage of the stop loss order is the possibility it offers the trader to not depend on his emotions. It is easy to get caught up in the game and hold a losing position for too long in the hope that it will eventually move in a more favorable direction. With the stop loss order, the position will be closed according to the strategy you defined at the beginning and without this psychological impact.
As far as the disadvantages of the stop loss are concerned, there is really only one. In some cases, your stop loss may be triggered by a spike in volatility. This will close your position even though the underlying trend may still be in your favour. This is why it is often advisable to place your stop loss order far enough away from the opening price of your position to allow for normal fluctuations in your asset. A stop loss order placed at 5% below the price of an asset that can go up or down by 3% a day is likely to be executed too quickly.
At what price level should a stop loss order be placed?
The answer to this question is quite tricky as there is no stable rule to determine the ideal gap between the buy price and the stop loss order trigger price. This choice will depend in part on your trading style as an active investor may place his order close to the price of the asset while an investor with a long term strategy will prefer a stop loss order further away.
Remember that once the stop loss is executed, it becomes a market order. This means that sometimes the selling price may be slightly different from the price you set with the stop loss. This happens especially in markets with large fluctuations. It should be noted that the execution price of a market order cannot be controlled and that it is executed in full and immediately. We know, for example, that if you own several securities bought at a given value with a stop loss order at another value, the sale of the first securities at the time of the execution of this order will be made at the indicated price but the following ones may be sold at a slightly lower price depending on the volatility of the downward trend.
It is also important to be aware that stop loss orders do not work during market closing hours and therefore do not protect investors from opening gaps.
How to use a stop loss order according to your strategy?
The stop loss order can be used in two major strategies which are scalping and swing trading.
If you are used to trading with a scalping strategy, it will be useful to place a stop loss order close to the subscription price in order to protect yourself against a quick market reversal. This method is particularly suitable for investors who invest mainly on the basis of macroeconomic announcements and who take positions within minutes of such announcements. In scalping, it is of course also possible to place stop orders further out in order to achieve a higher success rate. However, this method has a negative gain-loss ratio which means that the losses incurred are greater than the potential gains.
The second interesting stop loss strategy is swing trading. Here, you can choose to place a larger stop loss at the opening of the order in order to hold your position even if unexpected and volatile movements move the price of your asset in the wrong direction on a one-off basis. Of course, the underlying trend must be favourable to you so that you can earn more profit in the long run. Here you will have to determine the maximum loss you are willing to take.
Finally, as we mentioned earlier, if you want to hold a long position in the market but are unable to see the charts for a few days, for example if you are going on holiday, make sure you place your stop loss order far enough away from the opening price.
These two strategies, combined with a stop loss order and ideally a take profit order, are among the most popular investment methods in online trading. However, be sure to follow them precisely and always base your predictions on recognized methods of technical and fundamental analysis. Note that there are other programmable orders offered by trading platforms, including stop orders that are different from the one we have presented here.