April 02, 2020

Using a Stop Loss Order

Using a Stop Loss Order

Key Terms:

Trader– an individual that participates in the buying or selling of financial instruments, and typically plays around the short-term market trends.

Limit Order– is a type of order placed when buying or selling financial instruments that executes at a predetermined price.

Market Order– is a type of order placed when buying or selling financial instruments that executes immediately at the current market price.

Stop Loss Order– is a buy or sell order that triggers as the price of an asset moves beyond a specific price, and is used to limit downside risk or to lock in profits (LINKED TO MY TRAILING STOP ORDER ARTICLE). 

Loss Limiting– is a method used to control the extent of loss a trader can experience on any single trade.

Fill– is an event where a trader’s order is taken by another market participant.

ETH– is the trading symbol or “ticker” for the  native digital asset of the Ethereum blockchain

Let’s begin…

Novice traders find themselves at a serious disadvantage when they enter the financial battlefields. These battles are waged not over grassy plains, but instead on digital trading platforms. Instead of battle strategy and tactics traders use technical analysis and unique order types. One thing is certain and that is, you need training to effectively fight these battles. This principle also applies to amatuer traders, where specific knowledge and experience more frequently than not ultimately wins the day. Today’s lesson is on Stop Loss (SL) Orders, and how they can be used for loss limiting. 

Traders can set Stop Loss Orders to buy or sell financial instruments, while limiting the degree of losses that one single trade can yield. It takes extreme diligence and time resources to babysit every active trade a person may have. Setting pre-conditions using the key tools that trading platforms afford users is a no brainer. The need for tools like Stop Loss Orders are even greater in markets that are open 24/365 like Cryptocurrency. 

For the purpose of this article Stop Loss orders are broken up into two different methods of execution.

  • Stop Loss “Market Order”* (SLM) 
  • Stop Loss “Limit Order”* (SLL)

*Refer to the Key Terms section for definition

How it works:

Take the example of our friend Kim who has a strong belief the price of Ethereum is going to go up. Kim has a day job like most do, so she can’t track the live performance of her Ethereum trade. 

Our friend buys 1 ETH at $200, and to account for that reality she sets a SL 10% below her purchase price. What this means is if the price of 1 ETH reaches $180, the Stop Loss order will execute. Kim has 2 options at her disposal of how she would like the SL to behave. 

In the first option Kim sets an SLM, where when the price of 1 ETH reaches $180 the trading platform sells all of her ETH at the best possible market price. The major benefit of setting an SLM is barring unforeseen errors Kim will quickly sell all of her ETH. This method of Stop Loss will protect her from further financial losses if the price of ETH continues to fall. The major disadvantage of using a market order is the system will continue to sell the ETH until there is none left, regardless of the market price. So, there is no way to predict how low Kim sells her ETH until the trade is complete. 

Sometimes when the trading value of an asset drops sharply the price can temporarily rebound back towards the upside. In these cases using an SLL can offer the fewest losses for losing trade. In the second option Kim sets an SLL, where when the price of 1 ETH drops below $180 the trading platform will only sell all of her ETH at a pre set price. For simplicity, let’s assume Kim sets that limit sell order at $180. On one hand, if the price of ETH drops below $180 and rebounds back above that price Kim limits her losses to 10%. The biggest risk with using an SLL is if the price never rebounds back to $180, the ETH will never be sold resulting in additional losses.   

Takeaway

Stop Loss orders provide traders a way out of losing trades, and peace of mind while stepping away from the screen. Any trade comes with the risk of losses, but savvy investors find ways to account for those risks.  Protecting capital is a key tenant of smart investing and it is always better to live to fight another day.