Whilst trading in the financial markets can be exciting and potentially profitable, it also carries a level of risk that can lead to financial losses for you. To ensure that you have the best possible trading experience, it’s important to implement some risk management tools into your strategy. One essential tool that should be used is the Stop Loss Order.
What is a Stop Loss Order?
Before we get started, let’s clarify exactly what a Stop Loss Order is. When a trader (you) places an order with a broker or trading platform, you can instruct the broker to buy or sell a specific stock when it reaches a certain price, that’s set by you. This limits the investor’s loss if the investment falls in value.
It can also be used to ensure profits are retained, by selling when an investment reaches a certain price that’s set by you.
Why should I use one?
- Risk Management. The main benefit of using a stop loss order is risk management. By setting the maximum amount you’re willing to lose on a trade before you enter it, you can prevent large losses and ensure you stay within your risk tolerance.
- Time Management. It can be especially helpful for busy investors, to give you peace of mind. The orders execute automatically so the markets do not need to be continually watched.
- Diversification. Knowing that you have a safety net in place, you may feel more encouraged to diversify your portfolio and explore new opportunities.
- Emotion-control. Decisions can be based on rational analysis rather than emotions. By taking the emotion out of your decision making you can ensure that you consistently stick to your investment strategy.
- Capital Preservation. It’s extremely important to protect your trading capital. If you have a series of large losses it could wipe out your capital, leaving you with nothing to trade. A stop loss can protect you from one bad trade having a big impact on your overall portfolio.
- Preventing Revenge Trading. When traders suffer a loss on an investment, they may attempt to recover their losses by taking risky and impulsive trades. A stop loss enforces discipline and negates the need to recover large losses.
- Position Sizing. If you know the maximum amount you’re willing to lose on a particular trade, you can determine an appropriate position size that aligns with your risk tolerance.
As with anything, it’s important to take a balanced view and consider any disadvantages. When a stock is experiencing short term fluctuations, the stop loss order could be triggered, and you could miss out on long term profits. It takes away the investors’ opportunity to ride out the ups and downs of the market.
You must also consider the appropriate stop loss level for each investment. If it’s set too tight, then it could trigger too often and if it’s too wide then you won’t have sufficient protection.
In conclusion, managing risk in your investment is paramount. Stop Loss Orders provide a structured approach for controlling losses and preserving capital. They should be used in conjunction with a well thought out investment plan that considers market volatility and your individual risk appetite. Think of it as your safety net that allows you to trade with confidence and peace of mind.