What's a Stop Loss Order and How to Use It
To limit risk on a trade you need an exit plan. When a trade goes against you, a stop loss order is part of your exit plan. A stop loss is an offsetting order which exits your trade if a certain price level is reached.
Assume you buy the EURUSD forex pair at 1.1015, expecting it to rise. With this expectation, you place a stop loss at 1.1005 because your forex strategy indicates that if the price falls to this level it could go even lower before it goes higher. The stop loss order caps your risk at 10 pips per lot traded...theoretically.
When using stop loss orders there are a few things you should know though. While using them is always recommended, how they are used varies from trader to trader. Here are ways to use a stop loss order, stop loss order types and the pros and cons of using these types of stop loss orders.
Regular and Worst Case Stop Loss
There are two common ways traders use stop loss orders:
- A stop loss is used to exit all trades. The trader sets a stop loss on each trade at a price level they wish to exit a losing trade at. This is a regular stop loss and is used as the only exit plan for a losing trade.
- A trader manually exit trades as opportunities arise and conditions change, but may set a worst case stop loss order to limit losses in case a manual exit isn't possible or doesn't occur.
The stop loss, whether regular or worst case, serves to get you out of a position if you're disconnected from your broker because of an internet or power age (assuming your order made it to your broker before the outage occurred), or you need to run to the bathroom but don't want to exit your trade quite yet.
Using stop losses on a regular basis is a good idea as it forces the trader to be disciplined in getting out of losing trades. At the minimum, a worst case stop loss should always be used.
Stop loss orders execute automatically, which is often a good thing during a losing trade. Humans have a tendency to hang on to losing trades (loss aversion), so having a stop loss in place assures the trader limits all losses to a small amount of account capital.
Stop Loss Market Order
A regular or worst case stop loss is how a stop loss is used. Stop loss order types—market or limit—are the types of stop loss orders typically used.
The most common type of stop loss order is a Stop Loss Market Order. When the price of an asset reaches your stop loss price, a market order is automatically sent by your broker to close the position at the current price (whatever it may be).
Under most conditions, in a stock or asset with lots of volume (Look for These Qualities in a Day Trading Stock), your stop loss order will "fill" at, or very close to, the stop loss price originally set. In fast-moving market conditions (news events, for example), or a very thinly traded stock or asset, where the trade is actually exited could be quite different than the expected (stop loss) price.
This is called slippage and can result in a worse price than expected. It's one of the cons of trading with a stop loss market order. Some traders prefer to manually exit trades, as they believe they can manually exit when conditions are favorable, as opposed to a stop loss order automatically exiting their position in unknown conditions. This is why some traders opt to use only a worst case stop loss; they can exit most of their positions manually with hopefully less slippage. The flip side is that if trading liquid market slippage isn't a major concern anyway, so under most conditions using a stop loss to exit losing trades works well.
Stop Loss Limit Order
Another stop loss order type is the Stop Loss Limit Order. When the price of an asset reaches your stop loss price a limit order is automatically sent by your broker to close the position at the stop loss price, or better. Unlike the stop loss market which will close the trade at any price (current price), the stop loss limit order will only close it at the stop loss price or better. This eliminates the slippage problem (which isn't really a problem most of the time) yet creates a bigger one...it doesn't get you out of the trade when the price is moving aggressively against you.
If you went long a stock at $50, placing a stop loss limit order at $49.90, and the price moves to $49.88 (no one willing to buy your shares at $49.90) you need to hope someone now fills your limit order at $49.90. If the price keeps dropping without filling your order your loss grows, getting bigger than originally intended. This eliminates the point of a stop loss order—to get you out of a losing position.
The Final Word on Stop Loss Orders
If you're going to use a stop loss order, use stop loss market orders, not stop loss limit orders. If concerned about slippage—not typically a problem in liquid assets—then use a stop loss market order as your worse case stop loss, and exit manually when conditions are favorable. For most traders using a stop loss market order as their regular stop loss is highly beneficial. It assures you get out of losing trades automatically, so you aren't tempted to gamble and let losses mount. Don't avoid stop loss orders because you think you'll get stop hunted or your broker will give you horrible prices (see 5 Tips: How to Find a Great Forex Broker).
If this is happening it is usually because of a poor strategy or planning.