As we have already had the opportunity to speak and share during some previous appointments with this guide to trading, one of the most important concepts that it is essential to know when starting your personal trading career is represented by the appropriate strategy of money management. It is fundamental to understand what stop loss is, what its meaning is, but also what take profit is and what its definition is.
One of the most popular and appreciated tools to manage your money in every single position, in order to protect your capital, is represented by stop losses. But what are they? And why is it so important to set them?
What is the stop loss?
Stop loss is probably the trader’s best friend. If you’ve ever traded online before, you already know how a stop loss works and you are definitely using it for every trade (right?). If instead you have just approached the world of online trading, it is good to understand immediately how to use the stop loss.
The meaning of stop loss is quite easy to understand, it is a tool that literally stop (and so it reduces) your losses. It is really helpful for all traders.
Stop loss is a function available on practically every trading platform, which can be set or not for each trade. But what exactly is stop loss for and why is it so important?
The reason is simple: the stop loss serves to protect an investment by reducing the level of risk. Basically, this is a price level set after opening your own operation. If this level is reached while the position is open, then the trading platform will take care of closing your position automatically.
Obviously this price level set for the stop loss is chosen in the opposite direction to the one where the price should move. Or:
- If you open a long (bullish) position, you do so because you believe there will be a rise in the price of an asset. So you will set the stop loss in the opposite direction, to protect yourself from the possibility of a fall in the price instead.
- If you open a short (bearish) position, you do so because you believe there will be a fall in the price of an asset. Therefore you will set the stop loss in the opposite direction, to protect yourself from the possibility of a rise in the price instead.
In short, the stop loss is used to limit losses if the price moves in the opposite direction to the one expected. Not only that, if the stop loss is reached, the trading platform will automatically close the operation: another extra security, in case you are not in front of the computer.
The main advantage of having a stop loss is that you can calculate in advance, following your own trading strategy, the maximum amount that you are willing to lose on your investment. Without a stop loss you would risk becoming a victim of your emotions: maybe you see you are losing money with your operation, but you continue to keep it open thinking (and hoping) that sooner or later the price will move to the right direction.
You cannot imagine how many traders have burnt thousands and thousands of euros in this way, deciding to keep open positions at a loss. If in those cases they had set a stop loss, they would have avoided losing a lot of money.
What is the take profit?
Now that we understand what stop loss is, we need to move on to the next concept and understand how take profit works. Take profit is also available on every trading platform, and you can set it every time you open a trade. Obviously it is recommended to always set both the stop loss and the take profit.
If the stop loss serves to protect an investment from a possible loss, the take profit is useful to ensure profits for the trader. It is in fact a price level that is set in the direction in which it is expected that the price will move. Just like with stop loss, if the take profit level is reached while the position is open, then the trading platform will take care of closing your position automatically.
Also the meaning of take profit is quite easy to understand, it is a level (set by you) at which you want to get your profit.
- If you open a long (bullish) position, you do so because you believe there will be a rise in the price of an asset. So you will set the take profit in the intended direction, to secure your potential profits.
- If you open a short (bearish) position, you do so because you believe there will be a fall in the price of an asset. So you will set the take profit in the intended direction, to secure your potential profits
To better understand take profit, however, we need to explain the concept of “securing profits”. It may sound strange indeed, and it is legitimate to ask “Why will I have to put a limit on my potential earnings?“.
The reason behind the take profit is the same as behind stop loss. The take profit level is also a level that you calculate in advance, following your trading strategy, equivalent to the amount you are willing to earn for your operation and with which you feel satisfied.
Knowing this figure, as well as knowing what you would be willing to lose, will allow you to set stop loss and take profit correctly. Thanks to these two tools you can in fact keep under control your potential expected gains and losses, and thus better manage your capital even in the long term.
Furthermore, “securing profits” is not as easy as it seems. The first thing one feels to do when he finds himself with an open and profitable operation is to “let it go”, without limiting potential profits. But what if the prices change direction after a while?
We will probably be tempted to wait until prices return to at least previous levels, when we decided to let our operation run. And what if the prices never return to those levels but, rather, they change direction and move in the opposite direction causing a loss?
As you can see, having a level of take profit relieves us of all these doubts and problems. It is always better to calculate with a clear mind the stop loss and take profit levels, and then avoid running into unpleasant situations such as the one shown above.
Risks of the Stop Loss
Before discussing how to set stop losses and how to set take profits, it is good to pause for a moment on the potential risks due to the incorrect use of these two tools. Yes, because if on the one hand they can be of great help in limiting losses and better managing our capital, on the other hand they still hide risks.
As you have seen, both the stop loss and the take profit are price levels which, if reached, lead the trading platform to automatically close your trade. In one case to avoid further losses, in the other to secure profits.
The main risk when using these two tools is to badly choose the price levels to set them. For example, if you make a mistake in setting the stop loss, it is possible that the prices, during their normal fluctuations, reach this level leading to the automatic closing of your operation.
Let’s explain everything with an example. Let’s imagine that we have invested upwards, and therefore set the stop loss to protect ourselves from a fall. It is a pity that we have chosen a level too close to the current price trend, which with normal fluctuations touch our stop loss level by automatically closing the operation.
But as mentioned, these were normal fluctuations. In fact, shortly after the price begins to rise and here we have lost potential profits. We therefore need to avoid positioning our stop losses too close to the current price trend, and we must therefore study past movements to understand the best levels to position them.
Also because, otherwise, you risk falling into the opposite error, that is, placing the stop loss too far. This means that it exposes us to the risk of suffering greater losses. It is therefore important to find the right balance, studying the charts and analyzing past movements, but also the minimum and maximum levels touched by the prices.
Risks of the take profit
The take profit tool is also not risk-free. Take profit is used to secure profits, and as we saw in the previous paragraph, to relieve ourselves of many potential doubts and decisions dictated by emotions. But even in this case there is always the possibility of making mistakes.
Again, errors can occur when you set the take profit level too close or too far from the current price trend.
In the first case, there is a risk of “cutting” off many potential profits. Let’s imagine that we have invested upwards, prices go up, however, they immediately touch our take profit level: well, the operation is closed automatically by the trading platform and we secured our earnings.
Too bad, however, that prices continue to rise, and even a lot, thus making us lose excellent profits. The problem when setting a take profit level is that the “greed” factor often comes into play, since you need to find a limit on earnings (when in fact everyone would like to make money without limits).
If the limit is placed too close, there is a risk of having the opposite effect to that hoped for. So it could be spontaneous to say “but then I should put this Take Profit much further”, thus thinking of increasing your profits in future operations.
But even in this case they would only do damage. A level of take profit too distant may never be reached, this means that you will have to close the operation manually and then you will be exposed to the fateful question: “how much profit am I happy with?”. When in reality it is good to decide everything already at the beginning, before opening your own positions.
In short, even with the level of Take Profit it is necessary to find the right balance to avoid making the errors mentioned above. Always study the charts and price movements: only in this way will you be able to find the right level at which to set your take profit.
How to set stop losses
Setting stop losses is quite simple and, also for this reason, our advice is to never trade without them!
The stop losses can in fact be set when opening the position in the trading platform, indicating a price level at which the broker will automatically close your position. It is therefore a price that you do not want to exceed, and which will therefore allow you to protect the money that you have invested in that particular position.
In this sense, without anticipating the conclusions that we will then see in this study, we strongly advise you to establish stop losses for all (all!) positions, from the most risky to the most cautious.
Where to place the stop losses
Having clarified this, reaffirming once again how important it is to set the stop losses, it is clear how one of the most difficult things to do when opening new positions is to determine where to put the stop loss order.
Obviously, identifying these levels accurately isn’t easy at all. However, a first tip that we want to provide you is linked to the fact that, when you set a stop loss, you will be required to have an iron discipline, avoiding changing the limit if things are not going very well. For example, if you entered a long position (bullish), and the price starts to fall, you should obviously not lower the stop loss level in an attempt to give the market time to recover, obtaining a higher risk exposure than instead you had the opportunity to define. In short, avoid that your emotions exceed what is predefined, leaving the stop loss orders unchanged in any circumstance.
Why stop losses are really helpful
Many users neglect stop losses considering them as a hassle that they can simply avoid. Well, that’s not the case at all!
Stop losses are essential for any successful outcome of one’s strategy and, above all, for limiting the risks of which novice traders are not yet fully aware.
Not only that, in addition to allowing you to minimize your losses, and therefore remain on the financial markets for as long as possible with sustainable positions, the stop losses will allow you to achieve an unquestionably important goal: to reduce the level of stress that trading brings with it.
It is in fact easy to understand that maintaining a losing position without adequate protection is able to significantly increase the level of stress, thus leading the trader to irrational thoughts, especially when dealing with a not too experienced investor. The more the price goes in the opposite direction than the one desired, the more the stress will increase, until it gets to dominate the trader’s mind.
On the other hand, by appropriately setting the stop losses, it will be possible to get out of trouble quickly and automatically with tolerable losses, perhaps compensating them quickly by entering other more profitable positions, instead of focusing on a losing position for days and days in the hope that the price suddenly reverses the trend.
Techniques to set stop losses
Each trader uses a different technique when deciding where to place stop losses. Normally, investors prefer to use the technical analysis, helping themselves in determining the maximum loss levels, use tools such as support and resistance in order to find the most suitable point for the stop loss order. Still others use simpler tools, based on the amount of time that has elapsed since the position was opened, and so on.
In any case, probably the best method to start thinking profitably of stop loss is precisely linked to the possibility of starting from the most used method, represented by support and resistance. In fact, these levels indicate when a price reversal is likely to occur: the support could in fact indicate when a decreasing price will reverse its trend, while the resistance could indicate when a rising price will find an obstacle to its development. It follows that setting stop losses (and take profits) near supports and resistances could be useful to be able to funnel the position within predefined ranges.
However, supports and resistances are not the only tools you could use to set stop losses. We will return to this topic soon!