Risk Management And Stop Losses
Risk management is one of the most critical skill sets new traders to need to learn. When deciding on any trade or investment, the potential risks involved have to be considered carefully:
- Which financial market asset do you want to trade?
- Which offers a good opportunity right now?
- Will you buy or sell?
- At what price will you enter the trade?
- Where is your target?
And even before you enter the trade, you have to be clear on where are you wrong on the trade, and where you would exit the trade.
The answers to these questions will inform your overall trading strategy and the decisions you take around entry levels, targets and exit levels.
Together they will give you a basis for calculating your Risk Reward Ratio a crucial risk management metric.
Then you can make intelligent decisions about where to apply core trading risk-management tools: stops, stop losses, and exit levels
Let’s look at each of these in detail, and how can you use them to improve your trading.
Stop and Stop Loss
A stop or stop loss is an automated way for a trader to an exit an open position without having to be live on the trading platform. As a trading mechanism, it helps protect you from more aggressive losses than you may have wanted if the market moves against you.
It can also help you lock-in profits when you are making money. This removes the need to personally monitor all your open trades in real-time – something which is effectively impossible with modern markets being open 24 hours a day, 5 ½ days per week.
How to use stops in your trading
If, for example, you’ve bought a market with the expectation that it may go up, you would place a contingent stop order, linked to the long position below the current market price. If the price falls below that price, the open-long position would automatically be closed.
If you bought the GBPUSD Forex rate at 1.3000 (with an expectation for it to go higher), but it went lower, you could set a stop loss at 1.2900. If the market went lower and hit 1.2900, the stop would be triggered, and the long GBPUSD position would be closed automatically, with a loss of 100 pips (0.1000), and the actual loss multiplied by the position size.
Conversely, if you had a bearish view on Gold, and sold at 1600.00 with a view for a fall in the price, you might want to protect the amount you could lose by placing a stop order above the current market, for example at 1640.00. If the market went against you and pushed up above 1640.00, the short position would be automatically exited for a loss of 40.00 (again, multiplied by the position size).
It’s worth noting that when a stop is triggered, it does NOT necessarily have to result in a loss – not all stops are stop losses. Stops can be used to manage open positions when the market has moved in your expected direction so that the open position stays in profit.
Let’s return to the long position discussed above, buying the GBPUSD Forex rate at 1.3000.
The examples above would be deemed “normal” stop losses. Another type of stop loss is the trailing stop. A trailing stop loss is not set at a fixed position in the market but instead follows or “trails” the actual market price.
- If you have an open-long position, the trailing stop would be placed below the market.
- With an open short position, the trailing stop would be placed above the market.
The difference between a trailing stop and a normal stop is that, when the market moves in the direction you expect, the stop moves in that direction by a set percentage or absolute amount from the current market price.
The distance between the two is often described as the “trailing stop”. However, if the current market price then moves against our view, the trailing stop does NOT move.
Let’s look at an example.
We might sell the DAX German stock index (or on Hantec Markets, the GER30) at a level of 13000 with an expectation that the market will go lower, and a trailing stop set at 13100 or 100 index points away.
If the GER 30 went lower, then the trailing stop would move lower with the current market price, to remain 100 index points away from the current market. However, if the market moved back higher, the trailing stop loss would NOT move.
The trailing stop only moves in the direction of your trade expectation, so lower with a short position and higher with a long position. It does NOT then move back in the other direction if the market moves against your open position.
Let’s return to the Gold example above. However, this time we’ll assume you had a bearish view. Rather than wanting to sell now (where you would execute a market order) or sell at a price above (where you would place a limit order above the current price), you may only want to sell if Gold fell below the 1600.00 level, given that Gold was currently trading at 1620.00
For this, you would use a stop entry order.
There are two types:
- A sell-stop entry
- A buy-stop entry
A sell stop entry is an order to enter a short position, but when the market is currently trading above the trigger level. So, in the Gold example, the short position would only be entered when the current market price moves below 1600.00.
Conversely, if you had a bullish view and expected a market to rise in price, but only if it broke above a certain level higher than the current market price (in the case for Gold may be above 1650.00), you could place a buy-stop entry above the current market price. The long position would only be entered if the current market price moved above the buy entry order level.
In conclusion: Risk management and stop losses
The exit stop is an essential aspect of managing risk and central to any trading plan or strategy. You should dedicate as much time to understanding this area of trading as you would devote to the decisions to buy or sell.