A “stop” is a price level set below the current market price where an open buy trade is to be closed - in order to protect capital. It is the lowest level at which a trader is prepared to see the price fall.
However, this stop price is only the trigger point for selling the order and the actual sale may occur at a lower price, the difference in price being called “slippage”. Slippage is more likely to occur in volatile markets or markets with low liquidity.
A “stop-loss” is the mechanismto limit losses or protect profits. It is the broker order designed to protect the trader's buy order against falling prices, while allowing the benefits from rising prices.
Brokerage and Stop-Loss for Sell Orders
It should be noted that all brokers provide stop-loss orders in futures markets when either buying or selling the securities. In some countries, not all brokers accept stop-loss orders in the physical stock market.
This article simplifies discussion of the use of stop loss for buying into rising markets (“going long”). However, stop losses are equally applicable to selling into markets (“going short”) if the broker allows it. Of course, when short selling, the stop needs to be set above the current price to limit risk capital or protect profits as the market goes up against the trade.
Using Stop Loss - Types and Benefits
When a share reverses and retreats from its previous levels, a trader following the practice of selling holdings when the stop-loss level is reached will benefit by limiting losses or protecting profits. The trader can only control the timing of an order to close a position, meaning controlling the risk of losing more capital than allowed by the trading plan. There are two types of stops:
- A mechanical stop - an instruction placed with a broker to sell a parcel of shares if the price falls below a particular price.
- A mental stop - the setting of a level at which one decides to liquidate the trade should that price be hit. Applying mental stops is the usual practice when brokers do not accept stop-loss orders in the stock market.
Some Beginners Don’t Use Stop-Loss
Sometimes the trigger price may have been hit temporarily and the market then reverses, with the result that the trader misses out on subsequent gains once the market turns around. Many beginner traders view this as the stops being not useful. These beginner traders forget that the first trading concern should be the protection of capital.
Setting Stop-Loss - When and How
The stop should be set before entering a trade, as part of the trade plan. This is to limit the initial risk. Both a time and dollar stop should be determined.
- Time. The longer the trade is not in profit, the riskier it becomes, a sign that the analysis was faulty and the trade should be exited after a time.
- Dollar. Should the trade move favourably, the stop should be moved accordingly to protect profits. The stop should trail as the trade progresses.
The reader wishing to find out more details about where to place stops is directed to a related article, Methods of Setting Stops in Markets.
References:
- “Trading with a Plan”, Tony Compton & Eric Kendall. Wrightbooks. Elsternwick, Australia. 2000.
Harry P. Schlanger - Hello, I started out as a physicist working for research organisations. Mostly in the area of heat transfer in solids and porous media. ...
