Why Use a Stop Loss?
Say we have $1,000 to invest but are only willing to risk $200 on a single trade.
- First let us assume each contract of XYZ costs $1 ($100/ea.)
- Using no stop loss allows us to buy 2 contracts for a total cost of $200. If the trade moves against us the position will go to $0, and we will lose $200.
- Using a 20% stop loss allows us to buy 10 contracts for a total cost of $1,000. If the trade moves against us the position will go to $800, and we will lose $200.
- Now let us assume XYZ moves in our favor, and each contract is now worth $2 ($200/ea.)
- The 2 contracts we purchased have doubled and the position is now worth $400 (profit is $200 on a $200 risk making the risk reward 1:1)
- The 10 contracts we purchased have doubled and the position is now worth $2,000 (profit is $1,000 on a $200 risk making the risk reward 5:1)
In both scenarios A and B, the risk was the same; $200. Similarly in both scenarios if the trade moves in our favor the % gain is also the same; 100%. However, using a 20% stop loss in scenario B allowed us to purchase 5x the number of contracts as in scenario A. This results in a much better risk reward ratio if the trade moves in our favor as well as a higher capital gain. Using a stop loss not only will limit our downside potential, but also increase the upside potential by allowing us to take a larger initial position; all while keeping our risk defined.
What is a trailing stop loss order
While not every brokerage offers a trailing stop loss, a trailing stop loss order can help you move your stop loss us based on a predefined rule.
A trailing stop loss order is a type of trade order where the stop loss price isn’t fixed at a single, absolute dollar amount, but is rather set at a certain percentage or dollar amount below the market price. This allows the trade to remain open and continue to profit as long as the price is moving in a favorable direction. However, the trade will close if the price changes direction by a specified amount.
For example, let’s say you buy a stock at $100. You might set a trailing stop order at 10% below the market price. As long as the stock price keeps rising, your stop loss rises with it. So, if the stock goes up to $120, your stop loss would move up to $108 (which is 10% below $120). If the stock price then falls by more than 10%, your stop loss order would be triggered, and your shares would be sold.
This type of order provides flexibility, as it allows you to protect gains while giving a trade room to grow. Trailing stop loss orders can be placed for both long and short positions.