How to use a stop loss (trailing stop loss)

June 19, 2020

How to use a stop loss (trailing stop loss)

trailing stop loss

Most beginner investors just stick to market orders. They buy the coin/token they like and wait until it’s hopefully increased in value and sell it. When they’re ready to take the next step, they might decide to get a limit order which automates the process to the point where desired prices can sometimes be acquired. Limit orders set minimum price levels that need to be met in order for a buy or a sell to take place. For example, a sell limit order at $100 would not sell until someone came to the market and bought some of all of that sell limit order at $100.

In order to reduce risk further, the investor might decide to get a stop loss, which will be explained in detail here.

Order types: Market Vs Limit Vs Stop Loss

Market orders are great for the impatient buying, perhaps they have a bad case of FOMO (fear of missing out) and need to get their hands on the asset quickly. However, typically you don’t achieve the best possible price when using a market order. Limit orders give better prices, but they require patience. Also, with limit orders, it’s possible for the price to never meet limit order and the purchase to not go through so you have to weigh up the chance of the ordering going through with the degree to which the price is desirable.

What’s the purpose of a stop-loss?

A stop loss is intended to minimize risk attached to a trading position. By giving an automated solution, losses can be realistically contained so that stocks that fall rapidly don’t affect your portfolio returns too drastically. A rapidly falling asset could drag down your average returns considerably.

Who is the stop-loss designed for?

There’s no limit to who might need to use order typed that mitigate losses. Perhaps if you’re risk-averse you should consider using a stop loss or if you’re in a risky asset, such as one that’s awaiting market news or data, you might want to use a stop loss to contain a falling price at 5% rather than a 50% loss. 

How to limit your losses with a market order

When the trigger price or lower is reached, an order is then placed to sell the stock at the next available price. The key benefit to using a market order to cap your losses is the speed at which the trader gets out of the market. Due to this speed, the price might be lower than anticipated. 

The process of taking out this order is simple:

1. Set a stop price to buy/sell

2. Set the amount you wish to buy/sell

3. Wait for the stop price to hit and the order will go through at the next available price

For example, imagine you’re trading Tesla shares and you hear they’re unveiling a new protective car. You think it might go very well or very badly, potentially one of the windows might break, who knows?  You decide to cover any potential losses with the stock that you currently own. The stock is trading at $100 and you set the stop price at $90. When negative news comes out the stock price begins to fall. It falls past $90 and you sell at the next available order, in this case, it’s $89. The stock continues to fall and then settles at $85. You’ve managed to save $4 per stock despite losing $11 because of the fall in price. You’ve avoided an excess loss on this occasion.

How to limit your losses with a limit order

When the stock falls to the stop price that the trader has set, an order is triggered that seeks to fill at the limit price or better. To a certain extent, the price at which the stock is sold can be controlled. However, the stop may fall so quickly that the sell order is missed entirely, and the order doesn’t go through.

This is the process:

1. Set a stop price to buy/sell

2. Set your Limit price to buy/sell

3. Set the amount you wish you buy/sell

4. Wait for the stop price to hit

5. A limit order is automatically placed

6. Wait for a limit order to hit

For example, if you’re trading Bitcoin and want to minimize any losses whilst also having a strong degree of certainty as to exactly what price you might sell at, you might decide to take out a Stop Loss Limit. If Bitcoin is trading at $10,000 and you’re worried it may fall to a support level between $9500 and $9000. If it enters that range you want to be sure that you can sell at $9000 so when the stop price hits, your sell limit order is placed so that if it falls into the resistance level you have a high degree of confidence it will sell if it falls to $9000 again. You might do this to stop large losses that may occur if the price continues to fall. 

Trailing Stop

Instead of setting a specific price, you set a trailing amount or a certain percentage away from the market price. In a long position you set a trailing stop below the market price in an attempt to lock in profits.

Say you wanted to trade at $100, place trailing stop $5 below the trading price. If the price increases to $110, the stop price would rise to$95 to $105, staying $5 below the market price but if the stock were to start slipping the trailing stop would stay at $105. Minimizing potential loss.

1. Set a trailing stop level to buy/sell (either a price or percentage)

2. Set the amount you wish to buy/sell

3. Wait for the trailing stop price to hit 

For example, if you wanted to mitigate your losses and also maintain your potential profit levels, you might decide to use a trailing stop. You set a 5% stop level on an asset currently selling for $100 with the intention of selling if the price goes below $95. The price then goes up to $120 and the trailing stop rises to $114 (5% less than $120). This can continue to change so long as the price rises. If the price falls, the trailing stop stays put. Once the trailing stop is hit, the sale goes through.

In this case, you’ve managed to mitigate your risk whilst also maintaining your profit. Selling around $114, $14 above your starting point. 

Stop Loss: Market vs Limit vs Trailing Stop

There are benefits and drawbacks to all of these approaches, some have been highlighted already. For clarity’s sake, here are the benefits and drawbacks of each.

Stop Market

AdvantagesDrawbacks
● Best for those who want to leave the market quickly
● High level of reliability that the order will take place.
● Next available price might be significantly lower than anticipated. 

Stop Limit

AdvantagesDrawbacks
● High degree of price stability ● Possibility of inaction – Price may fall/rise so quickly that the opportunity to sell/buy disappears

Trailing Stop

AdvantagesDrawbacks
● Minimizes risk and maintains minimum profit levels ● Might sell your asset in a temporary pullback of a bull run