A stop loss is a limit order in which a trade is closed when a specified price is reached.
A stop-loss order is a defensive mechanism used to protect against further losses.
It automatically closes an open position when the exchange rate moves against you and reaches the level you specified.
For example, if you are long USD/JPY at 110.50, you could set it at 109.00. If the bid price falls to this level the trade will close automatically.
Stop-loss orders can only restrict losses, they cannot prevent losses.
Trades are closed at the current market rate, but in a fast-moving market, there may be a gap between this and the stop-loss rate you had set.
Stop Loss Placement
Placing stop-loss orders wisely is one of the abilities that distinguish successful traders from their peers.
They keep stops close enough to avoid sustaining severe losses, but they also avoid placing stops so unreasonably close to the trade entry point that they end up being needlessly stopped out of a trade that would have eventually proved profitable.
- A good trader places stop-loss orders at a level that will protect his trading capital from suffering excessive losses.
- A great trader does that while also avoiding being needlessly stopped out of a trade and thus missing out on a genuine profit opportunity.
Many novice traders make the mistake of believing that risk management means nothing more than putting stop-loss orders very close to their trade entry point.
It’s true that part of good money management means that you shouldn’t put on trades with stop loss levels so far away from your entry point that they give the trade an unfavorable risk/reward ratio.
For example, when you risk more in the event the trade loses than you reasonably stand to make if the trade proves to be a winner.
However, one factor that frequently contributes to a lack of trading success is habitually running stop orders too close to your entry point.
As evidenced by having the trade stopped out for a loss, only to then see the market turn back in favor of the trade and having to endure watching price advance to a level that would have returned you a sizeable profit…if only you hadn’t been stopped out for a loss.
Yes, it’s important to only enter trades that allow you to place a stop-loss order close enough to the entry point to avoid suffering a catastrophic loss.
But it’s also important to place stop orders at a price level that’s reasonable, based on your market analysis.
An often-cited general rule of thumb on proper placement of stop-loss orders is that your stop should be placed a bit beyond a price that the market should not trade at if your analysis of the market is correct.