A stop loss is a trading strategy used to limit potential losses in the event of an adverse market movement. It is essentially an order placed to sell a security if its price falls to a certain level, known as the stop price.
For example, suppose a trader buys a stock at $60 and sets a stop loss order at $55. If the stock price falls to $55 or below, the stop loss order is triggered. The trader’s shares will be automatically sold to limit the trader’s losses.
While stop loss orders can help limit potential losses, they do not guarantee that losses will be limited to the specified stop price. In fast-moving markets or during periods of extreme volatility, the price at which the stop loss order is executed may be significantly different from the stop price, resulting in larger losses than anticipated.
A stop loss order is a crucial tool for risk management and is used to protect invested capital and limit losses. There are a number of key reasons why stop loss orders are important in trading.
Stop loss orders help to limit their potential losses. By setting a stop loss order at a predetermined price level, traders can minimize their downside risk in case the trade does not go as planned.
Stop losses also remove emotional bias. Emotions such as fear and greed can cloud a trader’s judgment, causing impulsive decisions. Stop loss orders remove the emotional bias from trading decisions and ensures that traders remain true to their predetermined risk management strategy.
And finally, stop losses prevent large drawdowns. Large drawdowns can be devastating to a trading account and can take a long time to recover from. By using stop loss orders, traders can prevent large drawdowns and protect their capital from significant losses.
Market understanding is a critical factor affecting stop loss strategies. A trader having a good understanding of the market and its behavior is better equipped to set effective stop loss levels.
For example, a trader who understands the market can set appropriate stop loss levels that take into account market volatilities and price movements. A trader who sets stop loss levels too close to the current price may be stopped out of their position. A trader who sets stop loss levels too far away may risk losing too much money.
In addition, a trader who understands the market can recognize market trends and adjust their stop loss strategy accordingly. For example, if the market is in an uptrend, a trader may choose to set a trailing stop loss that follows the price as it rises.
A trader who understands the market can react to news events that may affect the market. For example, if a forex trader is trading a currency pair and a major economic announcement is due to be released, the trader may choose to tighten their stop loss levels to reduce their exposure to sudden price movements.
Consider the vastly different markets and dynamics of a cryptocurrency like Bitcoin and a forex pair like EUR/USD.
The best stop loss strategies depend on a trader’s trading style, risk tolerance, and market conditions. A number of effective stop loss risk management strategies are summarized below.
This stop loss strategy sets stop loss levels based on key support and resistance levels. Support and resistance levels are areas on a chart where the price has previously encountered buying or selling pressure and can act as potential levels for price reversals.
Traders set the stop loss level based on the support or resistance levels. For example, if the trade direction is up, traders set a stop loss below the support level to protect against downside risk. If the trade direction is down, traders set a stop loss above the resistance level to protect against upside risk.
Below is a stop loss level Bitcoin example based on a support level residing around $23,200. As can be seen from this chart, this support level is an area where the Bitcoin price has previously encountered selling pressure and tends to act as a potential level for price reversals.
Bitcoin Three Day Price Chart March 2023 (source: Morpher.com)
In this example, assume that Bitcoin was purchased on March 2, 12:00, for $23,244, and a stop loss was set at the noted support level. Later that day, when the price of Bitcoin breached this support level, the stop loss would have been activated well before Bitcoin bottomed out at $22,000, thereby limiting potential losses.
As the market moves, traders can adjust the stop loss level to follow the price action and ensure the trade remains protected. If the price moves in favor of the trade, the stop loss can be moved to break even or trailed behind the price to capture more profits.
The confluence stop loss strategy involves using multiple indicators or analysis techniques to confirm a stop loss level. Such indicators may include moving averages, support and resistance levels, previous highs and lows, Fibonacci retracements, trendlines, and channels.
This strategy aims to increase the probability of the stop loss level being respected and minimize the chances of being stopped out due to a false signal.
Returning to the Bitcoin example, a confluence stop loss can be utilized using a combination of two indicators: the previously selected support level of $23,200 and a Bitcoin previous low of $23,210. Using both indicators, a stop loss would again be set at $23,200. With this confluence stop loss example, the stop loss would have been activated well before Bitcoin bottomed out at $22,000, thereby limiting potential losses.
Bitcoin Three-Day Price Chart March 2023 (source: Morpher.com)
A volatility-based stop loss is a strategy that involves setting a stop loss level based on the volatility of the market. Volatility is a measure of how much the price of an asset fluctuates over a given period and can be calculated using a technical indicator such Average True Range (ATR).
To implement this stop loss strategy, calculate the average true range of the market using a technical indicator, such as the ATR.
Then, determine the trade direction based on the current market trend. If the trend is up, traders should look to buy. If the trend is down, traders should look to sell.
Traders can then calculate the stop loss level based on the ATR. For example, if the ATR is $0.50, traders may set the stop loss level 2 or 3 times the ATR value, which would be $1.00-1.50. This ensures that the stop level is wide enough to account for market volatility.
Returning to the Bitcoin example, it is noted that Bitcoin’s current ATR is about $764. Considering Bitcoin’s volatile nature, a stop loss can be set at 1 time this ATR. This would result in a stop loss price of $22,480 (the entry price of $23,244 minus $764). Using this ATR example, the stop loss would have been activated before Bitcoin bottomed out at $22,000, thereby limiting potential losses.
Bitcoin Three Day Price Chart March, 2023 (source: Morpher.com)
Overall, the volatility-based stop loss strategy is an effective technique to protect against downside risk and ensure that the trade remains protected. By setting the stop loss level based on the volatility of the market, traders can account for the fluctuations in price movement and minimize the chances of being stopped out due to a false signal.
A time-based stop loss strategy involves setting a stop loss level based on a predetermined time frame. These types of stop losses are typically used by traders who want to exit a trade after a certain amount of time has passed, regardless of the price action.
To implement a time-based stop loss strategy, determine the time frame for the trade. Once the time frame has been determined, traders can set the stop loss level based on their risk tolerance and the potential reward.
One example of a time-based loss is a daily stop loss. In this case, a trader may set a stop loss order to automatically close out their position at the end of the trading day if the price has not moved in their favor. For example, if a trader buys a stock at $50 per share and sets a daily stop loss at $48 per share, the trade will be automatically closed out at the end of the day if the stock price falls to or below $48 per share.
Returning to the Bitcoin example, for demonstrating a time-based stop loss, assume again that Bitcoin was purchased on March 2 at 12:00 for an entry price of $23,244. A time-based stop loss is set to automatically close out this position at the end of the trading day (18:00) if the price has not moved in a positive direction. As noted from the chart reproduced below, the price of Bitcoin has not trended in a positive direction. Therefore, the stop loss would have automatically activated at 18:00, well before Bitcoin bottomed out at $22,000, thereby limiting potential losses.
Bitcoin Three Day Price Chart March, 2023 (source: Morpher.com)
A percentage-based stop loss involves setting a stop loss level based on a percentage decline from a current market price.
For example, if the trader buys a stock at $50 and decides to set a stop loss at 2% below the entry price, the stop loss level would be $49. So, if the stock price falls to $49 or below, the stop loss would trigger, and the trader would exit the trade with a loss of $1.
In the example illustrated below, a percentage-based stop loss involves setting a stop loss level based on a percentage decline from a market entry price. Assume again that Bitcoin has an entry price of $23,244 and that a stop loss is set at 2% below this entry price: $22,779. Since Bitcoin’s price plunged below this stop loss price, the stop loss would be automatically activated, thereby limiting potential losses.
Bitcoin Three Day Price Chart March, 2023 (source: Morpher.com)
If the trader decides to adjust the stop loss level as the price moves in their favor, they could trail the stop loss behind the price. For example, if the stock price rises to $60, the stop loss level could be moved up to $58, which is 2% below the new entry price.
Stop hunting describes a trading practice that involves intentionally driving the price of a security to a level where stop loss orders are triggered, causing traders to incur losses. Stop hunting involves placing large volume orders to buy or sell at a price level that is close to the existing stop loss orders. When the price of the security eventually reaches this price level, the stop-loss orders are triggered. This causes a cascade of selling and buying that can drive the price further in the desired direction.
This practice is employed by larger traders or institutions that have the power to manipulate the market in their favor.
Stop hunting can be seen as a form of market manipulation, as it involves exploiting the weaknesses of other traders for personal gain. It is often associated with high-frequency trading, where computers and algorithms are used to execute trades at lightning-fast speeds.
Larger traders or institutions can use stop-hunting as a strategy to profit from these stop loss orders. By driving security prices to a level where a large number of stop loss orders are triggered, they can cause a cascade of selling that can push the price down further. This would then allow these larger traders and institutions to buy the security at a lower price. Thereby profiting from the subsequent price increase.
Stop hunting is more likely to occur in markets that are less liquid or have low trading volumes, where it is easier for larger traders to manipulate prices. It is also more common in volatile markets, where sudden price movements can trigger stop loss orders and cause a domino effect.
Stop hunting can be a frustrating and costly experience for traders, but there are steps that can be taken to reduce the risk of falling victim to this practice.
By placing a stop loss at a level that is less likely to be targeted by stop hunters, traders can reduce their risk of being stopped out. This means that the stop loss order is placed further away from the current market price, reducing the likelihood that it will be triggered by minor price movements.
Stop hunting often occurs during times of low liquidity or volatility. Therefore, it is important for traders to monitor the market closely and be aware of any sudden price movements or spikes. Traders should avoid trading during periods of high volatility, such as during major economic announcements or political events.
Traders can also use mental stop losses. A mental stop loss is a price level that the trader has set in their mind but has not entered as an order in the market. This can help traders avoid stop hunting as there is no order in the market that can be automatically triggered by manipulative traders.
Market understanding is a critical factor that affects a trader’s stop loss strategy. These traders can set appropriate stop loss levels and adjust their strategy based on market trends, thereby reducing their overall risk. However, no stop loss strategy is foolproof. Traders should choose a strategy that best fits their trading style and risk tolerance. Additionally, traders should be aware of stop hunting and the various ways in which it can be avoided.
Disclaimer: All investments involve risk, and the past performance of a security, industry, sector, market, financial product, trading strategy, or individual’s trading does not guarantee future results or returns. Investors are fully responsible for any investment decisions they make. Such decisions should be based solely on an evaluation of their financial circumstances, investment objectives, risk tolerance, and liquidity needs. This post does not constitute investment advice.
Hundreds of markets all in one place - Apple, Bitcoin, Gold, Watches, NFTs, Sneakers and so much more.