Stop loss tools are indispensable as a way to control risk
CONTRACTS for difference (CFDs) and spread betting require a strong stomach for risk. They are both leveraged products that allow traders to make predictions on the movements of thousands of live markets. As only a fraction of the total value of the contract is paid up-front, profits can climb to many times an initial stake. And losses can multiply just as starkly.
But your appetite for risk doesn’t need to be superhuman for you to be successful at trading – sleepless nights or wasted weekends needn’t be an inevitable consequence if you make use of an indispensable triad of tools.
Stop-loss orders, guaranteed stop-losses, and trailing stops can all limit stinging losses and, for various reasons, should be part of any trader’s vital defence mechanisms, especially in such a volatile market. Quite simply, they are instructions to brokers for action to be taken when a market hits a certain level. But they all have their appropriate moments – and it’s important to work out how they should be used, as well as when.
CONFIDENT TRADING
Chris Beauchamp, market analyst at IG Group, says “stop losses really are a must when it comes to trading, not just for the insurance against excessive losses but also for peace of mind.” Beauchamp hits on an essential function of these orders. Stop losses can provide a psychological protection against neurotic trading.
A stop loss works by automatically taking an investor out of a trade if the price drops below a predetermined level. Beauchamp uses an illustrative trade on BP as an example. If you buy BP when it trades at 400p, at £1 per point of movement, you may decide to put in a stop-loss at 380p. “Should BP drop to that level, you will be taken out of the trade with a £20 loss. If BP continues to fall over the next three days, then you have been spared an even bigger loss.” The protection the stop loss offers saves the trader the hassle of being glued to a trading screen all day – as well as potentially significant amounts of money.
STOPPED IN ITS TRACKS
However, stop-loss orders aren’t themselves always a guaranteed protection against loss. If the market takes a sharp downturn, and multiple stop-loss orders are triggered for multiple traders, it is possible for the stop to initiate at a different price from the one expected. Guaranteed stop-loss orders, for a fee, provide even stronger protection and (as per their name) guarantee that the stop will trigger at a pre-set price. If trading over the weekend, for example, especially when the news cycle is driving turbulence in the markets, a guaranteed order may provide peace of mind and protection.
But stop losses, whether guaranteed or otherwise, shouldn’t be set too tightly. Sandy Jadeja, chief technical analyst at City Index, uses a tool called the average true range, a measure of the average movement in a market over a given timeframe. Jadeja recommends placing stops “outside this average true range, to prevent a premature or false stop being triggered.” Especially when markets are turbulent, traders will not want to trigger an untimely stop, crystallising losses, when prices may move in the other direction later in the day.
There is, therefore, a downside to being too protective with stop loss orders. Potential profits will be limited if the trader is too rigid in the range of movement he or she will accept, even if potential losses will be minimal.
LOCKED IN PROFITS
Just as there is no need to manually and ceaselessly check up on trades, there’s also no need to manually adjust stop loss orders in line with a changing market. Trailing stops allow you to lock in profits as your trades move in the right direction. In Beauchamp’s BP example, if the trade moves in your favour and the price rises to 430p, you can put in a trailing stop at 410p, with an instruction to follow the price upwards at a distance of 20 points. So, according to Beauchamp, if “BP rises to 480p, and then drops back suddenly to 450p, your stop takes you out at 460p, locking in a gain of 60 points.”
Although not without limitations, stop loss orders are a sensible hedge against total CFD or spread-betting account wipeout. And they can be used creatively, a positive method of solidifying gains as much as a protection against negative losses. Crucially, they make it possible to make sensible money from a volatile market. Stop loss orders are an essential tool for any trader.