Let's be realistic: the only reason you trade is to make a profit. However, losses are inevitable, especially if you are trading in a volatile market.
But what if there is a way to reduce these risks?
You probably guessed that this is a Stop-Loss order, and you are right. In fact, it is one of the most common risk management techniques to limit potential losses. What is Stop Loss?
This is an order type used by traders to exit a position when the price moves against them until it touches a predetermined level. When the price crosses this level, the trading platform automatically closes the position to avoid further losses.
What is a Stop-Loss order?
A stop loss order is a versatile risk management technique used in trading stocks or even cryptocurrencies to effectively limit potential losses. At the same time, traders get the opportunity to trade with confidence. In most cases, traders use this order type to set a specific price level at which an existing order will automatically close if the price touches it.
And what is the most pleasant thing? It's all automated.
Technically, a stop loss is a conditional instruction that a trader gives to a cryptocurrency exchange. When the price of a cryptocurrency touches a given level, the order is automatically converted into a market order, which is executed at the next available price. A stop loss can be set at any price level and can instruct a cryptocurrency exchange to buy or sell a cryptocurrency, depending on the nature of the existing position.
An example is the chart below:
As you can see, we have a so-called Shooting Star candlestick pattern that usually appears at the top of an uptrend and anticipates a bearish reversal.
Let’s say you decide to go short and want to place an order to sell bitcoin. However, we are not sure that the price will move in accordance with your expectations - no trading model can guarantee that the price will move in one direction or another. Thus, we place a stop loss order just above the Shooting Star candle if the price continues to move bullish.
Presumably, this will happen, the stop order will be triggered, and we will take a loss. However, at least we know that the loss is limited, which helps us to control the situation. Luckily, the price shown in the example above continued to decline as planned and the stop loss was not triggered.
Ultimately, stop loss orders help you save time and make a profit. While the latter is triggered when exiting a profitable position.
Let's say if you use these orders, you will avoid the exhausting practice of regularly monitoring your positions. Stop orders are ideal for short-term traders who need to automate much of their trading process. If you are a swing trader holding several positions open for several weeks, you may not even need a stop loss as you check prices daily. However, using stop loss is very simple and you have nothing to lose by setting them.
Sell stop orders
Are you confused? Not worth it!
The rationale for this approach is quite simple. If there is an unexpected bearish reversal, you should know that a sell-stop order protects long positions in bull markets. This means that the order will automatically trigger a sell order if the price drops below a certain level set by the trader.
Thus, if the price has declined so far, it may continue to fall even further. Hence, the trader prefers to limit losses and the sell-stop order is used to automate the risk management process.
For example, let's say that a momentum trader has identified a bullish trend that may continue on its way. As shown in the example above, he entered a long position when the bullish candle broke above the local resistance level. He then set a sell stop loss just below the previous local support to protect his position. Thus, even if the price suddenly falls and touches the stop-loss level, he will take a limited loss.
Buy stop orders
A buy stop order is the exact opposite of a sell stop order. We use it to protect our short positions. In fact, the stop order in our first example is nothing more than a buy-stop order. It automatically initiates an exit by closing the short position when the price rises.
Can a stop loss order be used in cryptocurrency trading?
Of course you can!
In fact, not only can you use a stop loss order in cryptocurrency trading, but you must consider it if you want to be successful on your trading path.
Stop-loss orders are especially relevant for crypto traders given that cryptocurrencies are incredibly volatile and the market is not yet mature. Imagine that the price of bitcoin goes sideways, defying the logic of technical analysis; you will see your hard-earned balance wiped out within minutes.
Thus, a stop loss order is a way to stay on a safer path. Also, this is a required feature for most cryptocurrency exchanges, so there is absolutely no excuse not to use it, especially if you are a day trader.
How to use a stop loss order correctly
The main purpose of a stop loss is to limit potential losses. However, placing a sell stop loss order below the market price may not protect your long positions and vice versa.
You must learn how to properly use a stop loss order to get the maximum effect.
So where should it be placed?
That's how:
It depends on situation. However, as a general rule, you are interested in placing a stop loss near previous support or resistance levels. For example, you should place a sell stop loss just below a previous support level, whether it's an uptrend or a horizontal channel.
In our example, we placed a stop-loss order to sell near the previous reliable support. You can identify trend support by checking where price bounces back after touching an imaginary line.
However, if you are using specific strategies or relying on chart patterns, which is what we recommend, you should have precise rules for placing a stop loss order. For example, if you are trading a Head and Shoulders pattern, your buy stop loss is calculated from the distance between the pattern's neck line and its peak.
What is a stop-limit order?
A stop-limit order is a more complex order that helps traders protect their positions. A stop limit order combines a stop order with a limit order. When the cryptocurrency reaches the stop price set by the trader, a limit order is automatically triggered. The limit order is then executed at the set limit price or better.
Still confused about how a stop-limit order works?
First of all, you should know what a limit order is. Unlike a market order, which executes the order immediately, a limit order is executed when the cryptocurrency touches a certain level set by the trader.
So a stop-limit order has two orders and you have to set two prices:
- Stop Price – At this level, the price will trigger a limit order that will only be executed if the price touches the limit price set by the trader. Otherwise, the order will never be executed.
- The limit price is the second price that a trader must set for a stop-limit order. Once the stop price triggers a limit order, the limit price will only be executed if the cryptocurrency touches it.
In other words, a stop-limit order is a risk management tool that gives traders more control over the price at which the order should be filled. This order can work in volatile markets, so it is relevant for cryptocurrency traders.
Why do you need a stop-limit order if there is a stop-loss?
Stop-loss orders cannot protect your positions if the price moves against you and creates gaps, flash crashes, or even regular crashes that happen here and there during volatile markets.
For example, if you set a stop loss for Bitcoin in an uptrend at $30, the price could suddenly drop to $000 and your stop loss would be triggered at that price, meaning you would lose $29 more than planned.
Alternatively, let's say you use a stop-limit order with a trigger price of $30 and a limit price of $050. In this case, the order will be triggered when bitcoin drops to $30, and the position will automatically close only if it reaches $000 30.
For example, if it suddenly drops to $29, the order will not be filled. The order will be pending until the price of bitcoin potentially rises to $900, at which time the order will be filled.
How should a stop limit order be used?
You should always use a stop limit order. But it's even better if you use it during a volatile market and want to control your profits and losses.
For example, look at the chart below:
Let's say you decide to shorten Bitcoin's length when the red candle breaks below the previous support (1). You have set up a buy-stop-limit order with a stop price and a limit price.
In our example, the price suddenly bounces back and surprises you. It touches the stop price (2), which triggers the limit order. However, the order is not executed until the limit price is reached and the seller on the other end offers exactly the price you want (3).
But let's assume that the scenario described in point 3 didn't work. Suppose the price is volatile and suddenly crosses the limit price without execution because there was no seller on the other side (thus the price condition could not be met). In this case, the order will not be filled and will remain open until the bitcoin touches the specific price set by the trader in the limit order.
In our example, bitcoin comes back and crosses the limit price (4) again. There is an available price at which the order is filled and the short position is closed. A stop-limit order allows you to hold on and wait for the price to pull back.
Stop Loss vs. Stop Limit Orders
Stop-loss and stop-limit orders are similar in that their purpose is to protect open positions.
However, the difference between them shows up when the price hits the stop. In the case of a stop loss order, when this occurs, the position is automatically closed. The bad news is that the position may not necessarily close at the stop loss price, which can happen during flash crises or gaps.
Thus, in the case of a stop-limit order, when the price touches the stop, a limit order is triggered, which is executed only if the price touches the limit price.
A stop-limit order gives traders more control over their positions relative to the prices that trigger the exit. However, stop losses are easier to use and allow you to limit losses.
Benefits and Risks of Stop-Loss and Stop-Limit Orders
They are both designed to help you manage your positions more effectively. But did you know that they can also help you automate your trading process?
In fact, it is useful to help you focus on other tasks while you analyze the market for trading opportunities.
However, the downside is that even if you use either of these two orders, it does not mean that you are 100% safe from big losses.
Stop loss can fail during flash crises and price gaps, leaving you with bigger losses than expected. In contrast, a stop-limit order may not be triggered if the price does not exceed the limit price. Therefore, it will be better if you keep an eye on it, even if it is automated.
Сonclusion
So, stop loss and stop limit orders are great methods to minimize losses if the price moves against you. As the words of wisdom say, “practice makes perfect” and trading is no exception. Therefore, you should try to make as many mistakes as possible on a demo account before diving into trading. Make sure you understand how they work and choose one as your primary risk management method.