What Is a Stop Loss and When to Use It?

When it comes to trading anything with leverage, cutting out the damaging positions that can cripple your trading account is as important, if not more so, than spending hours researching which positions to back. Leverage can be a deadly weapon in trading terms, so taking measures to counteract its effects whenever possible is not only prudent, but absolutely vital to your success as a trader.

Indeed, ask any successful derivatives trader about the importance of stop losses and you’ll receive a unified response. Stop losses are automatic orders instructing the broker to close out (i.e. reverse) a position when a specific threshold low price-point is breached. Essentially, it’s a trigger to sell futures that are performing badly in a bid to cut your losses early and prevent the full impact of a rapidly descending position on your trading account.

To best determine when to use a stop loss, you should consider the following proposition: what do I stand to lose if my position drops 10%, 20%, 50%, 100%, and can I afford to lose it? If the answer is ‘no’ and you’re looking at a longer-term investment, it’s almost certainly worthwhile setting up a stop loss to keep a lid on the potential damage a losing position could cause.

In fact, so important are stop losses that some brokers even include them automatically with each newly opened transaction at a default generated level. Of course, these can be amended to suit the trader’s own requirements, but brokers across financial markets recognize the importance of having some lid on the losses that an individual transaction might bring.

Stop losses can also be put to innovative use in securing a takeaway profit from a losing position. Without limiting upside gains, it can be possible to position a stop loss underneath a new market high, in order to achieve the best of both worlds from a strengthening position – known as a ‘trailing stop’, this allows investors to lock in profits if the rising position dies away while also permitting the unlimited upwards growth in price.

So how then to position your stop loss to mitigate against the damage from losing positions? It’s all a matter of individual judgement, and it’s important to judge each case by its merits. What you want to ensure is that by positioning your stop loss order too tightly you are not jeopardising the success of your investment. Remember that prices naturally fluctuate in both directions – while you want to curtail runaway downwards positions, you don’t necessarily want to suffocate your chances of a profitable recovery.

A good rule of thumb for some trades is to position your stop loss just below (i.e. one tick below) the previous day/week/month low point. A price falling beyond this point will usually be headed further south, and by giving a certain benchmark you can make forecasts as to your potential downside liability and the chances of prices falling back to that low point over the lifespan of your investment.

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