Risk management, and with it stop loss is the most important strategy you'll have as a trader. If you're a part-time trader it will help keep you in the game and if you're a full-time trader it will make sure you always have food to put on your table.
Risk management is necessary because of all the inherent risks involved in trading, whether it's currencies, stocks, or commodities. Here are some of the pitfalls you need to avoid when trading:
- Currency pairs - interest rate changes, employment outlook, trade balance, economic growth, central banks.
- Stocks - business risk, bond callbacks, political risks, dividend reductions.
- Commodities - natural disasters or 'acts of God', supply and demand changes, political risk.
Even in the short-term, any minor change can create incredible market fluctuations. This is why setting a stop loss is the most important part of your risk management strategy. Below, you'll find everything you need to know about setting an effective stop loss.
The Basics of a Stop Loss
A stop loss is the amount of money you're willing to lose in a single trade. Once you reach your stop loss, you need to sell immediately and cut your losses. If it goes further than that, your bankroll and mental state will suffer.
Setting a stop loss is important because it ensures that you won't lose everything in a single trade. In volatile markets, especially when trading on leverage, it's possible to lose incredible amounts in a single day. A stop loss takes psychology out of the equation and doesn't let you hang on to a loser because it's 'due to bounce back'.
The most important thing in setting a stop loss is sticking to it. It's easy to say that you'll sell once you've incurred a certain amount of losses, but actually doing it can be tough in the heat of the moment. Nobody likes to make a losing trade. If you find yourself having difficulty following stop losses, consider using a trading bot that will enforce your stop losses for you automatically.
Choosing Your Stop Loss Point
Stop losses can be tricky to pinpoint since there isn't any set formula or percentage for defining one. In general, it will vary based on the types of trades you make, and how much loss you're willing to endure, financially and mentally. If you tend to take losses especially hard, for example, you should set your stop loss a bit tighter. Keep in mind that setting it too tight will reduce your chances of rallying, and end up hurting your bottom line.
Here are some things you need to keep in mind when setting your stop loss points:
- Set your stop loss on moving averages for long-term assets and dollar figures for short-term trades.
- Use more forgiving points for long-term volatile assets so you don't trigger a stop loss on a standard price swing.
- Adjust a stop loss to compensate for reasonable price ranges.
- Keep a market's volatility in mind when selecting a stop loss. The more volatile a market is, the larger the stop loss needs to be to compensate for reasonable swings.
- Err on the side of caution when starting out, especially when your bankroll is small.
If you aren't sure where to set a stop loss point, it's a good idea to look at an asset's resistance point. This is the point at which a price usually rebounds, and is a good estimate of the asset's current floor price. Once prices fall below the resistance point, it usually continues to fall very quickly. Setting your stop loss at this point is a good way to ensure you don't take a bath while making sure you have a reasonable chance of rebounding.
One Final Tip: Setting a Take-Profit Point
A take-profit point is the point at which you're definitely selling. If you're trading in the short-term, a take-profit point is vital. Without one, you risk losing potential gains and lowering your overall profitability.
Much like a stop loss, you need to carefully analyze a market to guess at what the highest price it could possibly bear is. Once you reach that point, you'll want to sell.
Now that you have the basics of setting a stop loss down, you're ready to trade without risking your livelihood. Make sure to create an account with us today to get started!