Stop-loss orders are an invaluable tool traders can use to minimize risk. These market orders act as a safeguard against unpredictable movements. Here’s how to utilize them.
A certain degree of risk is unavoidable when it comes to investing, but what if you could greatly reduce it for every trade? Trading crypto is difficult, with all sorts of tools and options to consider. However, there is one tool that every single crypto trader needs to know: the stop-loss order.
A stop-loss order will help you avoid any major losses from a negative price movement. This risk management technique saves traders from getting stuck in a market spiral by automatically liquidating assets. This article is your ultimate guide to understanding the stop-loss order and how to best use it.
What is a stop-loss order?
A stop-loss order is a type of market order, which traders set to execute based on future conditions. Traditionally, stock investors would place their stop-loss orders with their broker. Now, traders can set up their orders through a crypto trading platform like WABLI.
This type of order is designed to sell (or liquidate) your crypto once it reaches a certain price, lower than the current market price.
Suggested reading: Market Order vs. Limit Order: Which One to Use and When?
For this reason, stop-loss orders are incredibly useful for minimizing the loss of a certain position. Rather than relying on a set period, a stop loss order is executed based only on price. It can therefore act at any time, no matter how fast or slow the market is. Once your crypto reaches the stop loss price, a sell order for it is immediately distributed at market price.
Benefits of a stop loss order
Here are several benefits of opening a stop-loss order:
Minimizing loss
The main benefit of using a stop loss order is getting to set specific parameters on your trades. It allows traders to decide exactly how much of a loss they’re willing to accept, based on their financial terms.
Making logic-based decisions
Many traders work in a fast-paced environment, with constant market movements and trade opportunities. In the chaos, it’s easy to allow your emotions to take over and make unsound decisions. With a stop-loss order, traders can know their trades are protected without having to worry. It reduces the need for quick decisions fueled by greed or fear. It also keeps traders on track with their financial plan, not allowing for any delays in liquidating the crypto when it falls.
Cost-effective
Stop-loss orders cost nothing to implement, making them a cost-effective risk management strategy. It almost acts like an insurance plan, but comes with no fees (unless you pay a broker to manage it for you).
Saves time
Stop loss orders allow traders to live without having to constantly check on their positions.
Locks in profits
A stop-loss order is customizable and useful for locking in returns - not just limiting losses. Traders can use a trailing stop, which is set in percentages. The stop order will trail the price as it moves up (for selling the crypto) or down (for buying more crypto). Using it, traders can sell their crypto once its price increases, instead of when it decreases.
Stop-loss order example
Let’s explore a realistic scenario where a trader can use a stop-loss order. Let’s say that we have a trader, named Sarah, who invests in Bitcoin (BTC). Knowing BTC is a volatile asset, she wants to automatically sell if the price drops below a certain threshold. These are the steps she takes to set the order:
Assess market conditions: Sarah analyzes Bitcoin’s past market trends and current market sentiments. She wants to determine her stop-loss level, and how likely the crypto is to fall. In this example, let’s say Bitcoin is currently $25,000.
Set the stop loss level: Logging into the crypto trading platform she uses, Sarah creates a new stop loss order. This includes specifying the order as ‘Stop loss’ and the action as ‘Sell’. She inputs the details of her position and sets the price to $22,500, or 10% lower than the current price.
Place the order: Once she’s filled out all the information, she double-checks all the information. She clicks ‘Confirm’ or ‘Place Order’ to confirm it. She will then receive a notification from the platform that the stop loss order is indeed submitted and working.
Wait for it to execute: Sarah can keep an eye on her Bitcoin. Let’s say that the crypto does fall below $22,500 - it will automatically submit a sell order.
Disadvantages of a stop-loss order
A stop-loss order’s main disadvantage is that a short-term price drop could activate it. In the example above, Sarah’s Bitcoin falling to $22,500 activates her stop-loss order. However, her Bitcoin may then rise in price significantly. In this example, Sarah will lose out on the possible profit she could have made by selling too quickly.
Another disadvantage is there’s no guarantee that your sell order for your crypto will sell at market price. This is especially true if the crypto’s price continues to fall. Sarah’s sell order is placed at $22,500. However, she may only receive offers for $22,000 (or less).
Is stop loss a good strategy?
Stop-loss orders are a great risk management strategy for any kind of trader, and they have a long history proving so. However, it’s important not to rely solely on stop-loss orders to protect your positions. It’s important to have a good grasp of the market you invest in by
analyzing trends,
historical data,
and recent news.
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Comparing your stop loss to your financial plans is also necessary. For example, day traders might set their price to a 5% decrease, while long-term traders set theirs to a 15% decrease.
Understanding the limitations of a stop-loss order, and using other strategies - like other market orders, trading bots, and a diverse portfolio - to minimize risk is also crucial. When paired with other tools, a stop-loss order’s effectiveness strengthens. Staying active and participating in your trades will improve your skills and help you set better orders.
How to know when to execute a stop-loss order
One popular strategy is the 2% Rule. This means traders never put more than 2% of their equity at risk. For example, if you are trading $50,000 and you choose a risk mitigation stop loss of 2%, then you can risk up to $1,000 on any given trade.
You should execute a stop-loss order when you feel you don’t want the pressure of monitoring crypto prices every day.
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