A stop-loss order is a risk management tool you can use to limit potential losses. Standard stop-loss orders are free, though a variant known as a guaranteed stop-loss order is a paid-for service that offers an extra layer of protection. Here we will look at both of these along with their pros and cons.
A stop-loss order tells your broker to close your position once it reaches the specified price. You use it to limit your potential losses should the market move in the wrong direction. For instance, If you set a stop-loss order 10% lower than the price you bought at, you will limit your potential loss to 10%.
There is no charge for placing a stop-loss order, so apart from certain exceptions, there is no reason for not doing so. Try to think of it as free insurance.
The additional advantage is that you make your decisions in advance and so immediate circumstances and emotions do not alter them.
Importantly they also steer you clear of the sunk cost fallacy where you might argue with yourself that you have already seen a loss (your sunk cost) so you might as well hang on in a little longer to see what happens. That is almost always a wrong decision as it usually leads to increasing losses.
As William O’Neil said:
“Letting losses run is the most serious mistake made by most investors.”
Setting a stop loss will prevent you from making this mistake.
Using Trailing Stop-Losses
Another aspect of stop-loss orders is to manage a position as it goes along by using a tool called a “trailing stop loss.”
In this case, you set up a trailing stop by setting your stop-loss order at a specified percentage below the current market price rather than the price at which you bought. The price of your stop loss will change as the instrument’s price changes.
If the price increases, you have a virtual gain, but you don’t have the cash until you close the position. With a trailing stop, you can let the price run while locking in a profit.
The flip-side of a stop-loss order is a take profit order, which will close your trade if a specified level of profit is reached. They work in the same manner as stop losses.
What is a Guaranteed Stop-Loss?
A guaranteed stop-loss order (GSLO) is similar to an ordinary stop-loss order, but with the additional feature that it is guaranteed to close your trade at a price you specify. That happens regardless of any other parameters such as price gapping or slippage. These are closely related:
- Gapping is when prices change suddenly between levels without taking on intermediate values. It is often a feature of unexpected announcements, the release of economic data, or significant world events. While gapping can occur at any time, it is more likely to happen soon after a market opens following a closed session. Sometimes gaps can be huge, as in the case of the Swiss Franc-Euro debacle of 2015, when the gap was so big it sent a number of both traders and brokers bankrupt!
- Slippage is the difference between the anticipated price of a trade and the actual execution price. It usually occurs when liquidity is low, as in the situation where there is a large discrepancy between the numbers of buyers and sellers in the underlying market often as a result of high volatility.
If you use a GSLO, you will usually have to pay a premium (GSLO Premium), typically 0.3%.
The good news though is that there is at least one broker who doesn’t charge extra for guaranteed stop loss orders and that is Easy Markets.
Guaranteed Stop-Loss Order Example
Let’s assume you intend to go long on the FTSE 100. The sell/buy price is 5915/5916. You buy one unit at 5916. The market is currently volatile, so you play safe and place a GSLO at 5870 to limit your potential losses. Your stake is one GBP per point.
Unexpectedly, the U.S. Federal Reserve cuts interest rates resulting in overnight volatility in the markets. This creates a FTSE 100 gap of 80 points. The next morning the FTSE 100 opens at 5835/5836.
However, as you had a GSLO, your trade closed at 5870, which limited your loss to:
- 5916 – 5870 = 46 GBP
Without the GSLO in place, your trade would have closed at the next available price, your loss would have been:
- 5916 – 5836 = 80 GBP
Thus you reduced your loss by 34 GBP, though this will be reduced a little by the GSLO charge.
If you are going to use guaranteed stop loss orders, it is worth checking out your broker’s terms and conditions to ensure it really is what it claims to be. You want to be sure there aren’t any caveats and their GSLO does truly cover gapping and slippage.
Should you Always use a Stop-Loss Order?
As we said, essentially a stop loss is free insurance, and a guaranteed loss is also a valuable insurance policy though normally you do need to pay for it. But are there times when it’s better not to use a stop-loss order?
The main problem with stop-loss is that a short term price fluctuation could activate the order. Triggering a sale prematurely is permanently locking in a loss and paying an unnecessary commission on the sale. That is why some traders set a stop-loss a fair distance from their opening price, to ensure that a slight fluctuation doesn’t take out the stop loss inadvertently.
An alternative reason for not using a stop loss would be an occasion where a trader has enough funds to cover a position effectively going to zero or its worse possible outcome. In this case they are prepared to “wait out” any move against them and for the price to bounce back.
Obviously the risk with this approach is the price never bounces back and they end up losing a huge amount – as well as paying a lot of interest for holding the position potentially for a long period. Worse, if they have a sell (or “short”) position and the price just keeps going up and up indefinitely they could be looking at catastrophic losses. The “wait it out” strategy is rarely a good idea and certainly not suitable for most traders. It is a very risky approach indeed.
Beware Unscrupulous Brokers
The other danger to be aware of is that brokers have been known to engage in price manipulation to take out the stop losses of their clients. This is more likely to be the case where the broker actively takes positions in opposition to their clients, profiting when the client loses money on a trade.
This is why some traders use “manual stop losses,” which means they don’t enter a fixed stop loss with their broker when they open a trade but rather decide in advance on a price they will close their trade at and then monitor the trade themselves and close it manually when the position hits that predetermined level.
Such an approach takes a lot discipline and is not recommended for most traders however, as the risk is that people don’t actually close out their position at the price they had decided on beforehand and instead let it run in the hope it jumps back up. The danger is they end up with much bigger losses than anticipated.
On the MT4 trading platform, some forex robots claim to have a “stealth mode” whereby they use stop losses but don’t reveal them to the broker, to prevent them from engaging in price manipulation. If something like this actually works then it is certainly a good innovation.
On the whole though, it is worth looking for reputable brokers who do not trade against their clients’ positions. This will reduce the chance that they will engage in price manipulation. If they aren’t trading against you then there wouldn’t really be a reason to close out your stop losses unnecessarily.
One of the most reputable brokers and one who supposedly don’t trade against their clients is IG Index. It is worth going to a reputable broker as the differences on these kinds of issues can really add up over time.
Conclusion – Should You Use a Stop Loss?
The decision as to whether to use stop-losses or not rests with each individual trader and each circumstance. For the vast majority of traders however we would argue it is a good idea to use them.
As Tony Saliba once said:
“I always define my risk, and I don’t have to worry about it.”
That is a sensible approach to trading and as he suggests, takes the worry out of it.
If you are using a reputable broker who isn’t trading against you then really there should be no reason for them to manipulate prices to take out your stop loss positions so you should be comfortable using stop losses with such a broker.
If you want that extra bit of protection, then guaranteed stop losses can also be a good idea as markets do gap up and down from time to time, often completely unexpectedly. In most cases you will have to pay extra for the privilege of guaranteed protection but it gives added piece of mind.
All in all managing your risk is a crucial part of being a successful trader and stop losses are an important part of that. If you are not already using them, it is certainly worth considering doing so.