Stop loss order, or stops and stop losses, are used by traders to leave a trade once the trade becomes a loss or when the market moves against the trade. Every trader, no matter how new or old you are in the game, must use stop loss orders as this will limit your losses. However, there are some traders who do not use stop loss orders because the loss can be overcome when the stop loss order is placed at points where not all other stops are (e.g. the less obvious places). There are no rules set in stone as to which levels you should place your stop loss order at, but there are general guidelines you can follow to help you place a stop loss order correctly.
Read on to find out how to use a stop loss order to exit a trade.
- Decide which type of trader you are – a system trader or a discretionary trader. This is important because the method you will use to place your stop loss order is highly dependent on the kind of trader you are.
- If you are a discretionary trader, you must place your stop loss order at the price where the market is less likely to trade at. Why? Because when you place your stop loss order a certain price, you can actually change the direction of the market when this price is traded at. The idea behind the discretionary trading method of placing a stop loss order is that if the market reaches the stop loss price, you will want to exit the trade. The stop loss is thus the point where you leave the trade.
- If you are a systems trader, you must place your stop order loss according to your trading system’s ratios of risk to reward and win to loss. For instance, if your trading system’s ratio says that the optimal stop loss distance is 15 ticks beyond the entry price you put in, your stop loss order must also be placed 15 ticks behind the entry price. The systems method is dependent upon certain mathematical equations, and the trader’s discretion does not play a part in the decision of where the stop loss order must be placed.
- Alternately, a systems trader can also place a stop loss order according to indicators. For instance, if you discover that certain indicator patterns provide you with an optimal trade exit, you will base the placement of your stop loss order according to the indicator pattern instead of the ratio.
Discretionary traders must consider the reasons why they chose to place the stop loss order at a certain price. Discretionary stop loss orders must be based upon the market dynamics, or they will be ineffective in protecting you from potential losses. If you do not know why you chose to place your stop loss order at a certain price, this is not the right stop loss.
System traders must have mathematical calculations that reveal where the stop loss order must be placed. The results must be followed exactly; otherwise, you are adding unnecessary risk rather than protection.