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Sun, May 19, 2024

How to use Stop Loss – The Benefits, Drawbacks, & Alternatives

What Is A Stop Loss

The Stop-Loss order is one of the most useful tools available to protect investors from suffering significant losses. Even though many investors aren’t aware of terminologies like stop loss or stop-loss order, it can be a lifeline for those who use it.

Some people use it well to prevent losses from their investment adventure, while others don’t use it at all since, they don’t know enough about stop-loss orders. When it comes to investing, making use of a stop-loss order in an appropriate and effective manner will make a significant difference. Stop-loss orders are something that everyone who invests in the financial markets should be familiar with before they start trading.

Benefits of Stop Loss

There are a couple of benefits to using a stop loss which is why they’re quite popular among traders worldwide. If you’re skeptical about using a stop loss, you might want to go through some of the benefits below in order to change your mind:

No Extra Charge

The fact that a stop-loss order does not incur any charges to put into effect is perhaps the most significant advantage it offers. Only once the stop-loss price has been reached and the asset needs to be sold will you be responsible for paying the standard fee. A stop-loss order can be compared to a free insurance policy, which is one way to think about it. This is also why it is used so often as traders know they are not getting charged for it. You can edit and remove your stop loss however many times you like without fear of losing any capital.

No Regular Monitoring

In addition, when it comes to stop-loss orders, you do not need to follow the performance of a stock on a daily basis in order to make adjustments. This convenience comes in especially helpful when you are away from your assets for a lengthy period of time, such as when you are on holiday or otherwise engaged in activities that prohibit you from monitoring your investments. Most people don’t have the time to watch the markets 24 hours a day, 7 days a week. This is why they usually use stop-loss so they can go about their everyday activities without worrying that they’re going to face a margin call.

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Helps in Survival

If you lose your investment, you can’t trade, clearly. In a similar fashion, if you lose fifty percent of your capital, you will need to make a profit of one hundred percent in order to recoup the previous high point of your equity. Avoiding the possibility of complete financial devastation and maintaining participation in a game are the primary goals of using stop losses. This is by far the most significant benefit that comes with using a stop loss. There is not a single trader who would want to face a loss as a result of not being careful enough. When we play with our emotions, we tend to make many mistakes. This is why placing a stop loss will significantly help with the survival of your trading account.

Flexible Movement

Depending on the motion that occurs up until the execution of the trade, a trailing stop may either act as a stop loss or a stop profit. When it comes to investing in the stock market, one of the worst clichés is that you won’t go bankrupt if you take profits. It is difficult to disagree with that, but at the same time, it is quite unlikely that you will ever amass a significant amount of money either. As a result, you need to ensure that you give your trades space to go in the direction you want them to go. This way you can prevent losses and gain profits as well.

Drawbacks of Stop Loss

There are a couple of drawbacks to using stop loss which is why some traders choose not to do so. If you’re an avid stop-loss user, you might want to take a look at these drawbacks in order to change your mind:

Not Ideal in Fluctuations

The primary drawback is that a relatively little shift in the price of an asset over a short period of time might trigger the stop price. The goal is to choose a stop-loss proportion that permits an asset to move up and down from day to day while at the same time protecting the investor from as much potential loss as feasible. If an asset has a history of fluctuating by 10 percent or more in a single week, it is possible that placing a stop-loss order for 5 percent of the asset’s value is not the most effective technique. It is quite likely that the only thing that will cause you to lose money is the fee that is created as a result of the implementation of your stop-loss order.

No Guarantee

Additional potential dangers are posed by stop-limit orders. These orders have the ability to ensure a certain price ceiling, but the deal itself might not be carried out. During times of high market activity, this can be detrimental to investors if the stop order is executed but the limit order is not filled in time to prevent the market price from exploding past the limit price. If negative information is released about an asset and the limit price is just $1 or $2 lower than the stop-loss price, then the trader is required to keep holding onto the shares for an undetermined amount of time until the share price begins to increase again.

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Backward Logic

Trading in the foreign exchange market, which is known for its strong tendency toward mean reversion, will result in a currency pair being cheaper as it continues to decline. The numbers speak for themselves. If the price continues to fall, then the risk will continue to grow. This has traditionally meant greater rewards in the years to come. The foreign exchange market has, over the course of the past three decades, provided compelling evidence of mean reversion. Hence, each dip has been followed by greater odds of increasing returns in the immediate future.

Overnight Gaps

The majority of people say that stop loss should be used so that significant and unpredictable losses may be avoided. If you don’t use one, it’s only a matter of time until a significant loss eliminates your position or maybe your account entirely. However, the majority of losses that are uncontrollable occur overnight when an asset you own goes against you. These tactics are known as overnight strategies. Because of this, you won’t be able to restrict your losses, but you may, on the other hand, limit the potential size of your profits if you sell anything or fill up large gaps. You will need to trade in smaller sizes in order to avoid this.

Stop Loss Alternatives

We’ve just explained some key points in the benefits and drawbacks of using a stop loss. If after going through these points you believe that a stop loss is not for you, there are some alternatives that you may prefer. They are as follows:

Explore Different Assets

Why limit yourself to just one type of investment, for instance, currency pairs? In addition to trading equities and stock indexes, you should also trade commodities such as gold, gasoline, Treasuries, the Nasdaq, silver, oil, and gasoline. These are just a few examples. You should even engage in the trading of cryptocurrency. The goal is to achieve returns that are not connected with one another. As long as you expand your portfolio and make it more diverse, you’ll have a better chance of avoiding trading assets that aren’t performing too well.

Try Different Time Frames

There is no time period that is better or worse than any other, and we seek methods that are effective for decades as well as for as little as one to four hours. Why put restrictions on yourself? When it comes to trading, one dollar made in day trading is equivalent to one dollar made in swing trading. The return you earn on a day trade may have no relation at all to the profit you get on a swing trade that lasts for two weeks. The reason most people don’t use this strategy is that they don’t have the patience to do so. If you believe you’ve got enough patience, we highly recommend that you for it.

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Experiment with Long and Short

The majority of traders, at least in terms of forex pairs, focus mostly on the long side of the market, but they enjoy using short methods since they may help to smooth out returns. The disadvantage of using shorts is that they are more prone to unpredictable motions, and it is also quite difficult to locate shorts. Short selling is challenging, but there are just a few tactics that may make a significant difference in mitigating risk. Most beginners like to stick to either short or long. You have not really tried forex trading until you’ve experimented with both.

Change Position Sizes

You could want to think about utilizing a smaller position size as an alternative to stop-loss. Always trade in smaller lots than you would like since this is the fundamental guideline that we go by in our trading. Because of this, the likelihood of you making behavioral errors is significantly reduced. Keep in mind that the total degree of risk associated with your trading account will be impacted by the size of the positions you hold. When you increase the size of your position, you also increase the size of any eventual losses. Check to see that your investment in a single position does not represent an excessively high proportion of your overall account balance.


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