A stop-loss is an advanced order that is used by traders to prevent additional losses. When a specific price point is met, the order is triggered and closes the existing position. Trades can always go bad, so it is important to cut one’s losses early and establish good defensive mechanisms ahead of time.
As the market experiences a pull-back, a stop-loss can trigger to trade funds out of the current position. Due to the volatility of the cryptocurrency market, stop-losses are a fundamental aspect of the trading experience that is often necessary for long-term profitability. In this lesson, we will explore how a stop loss works and how to use it.
A stop loss order allows traders to limit their losses by setting a stop price - a price level that when reached, closes a position. Stop losses are particularly efficient when margin trading, considering that any significant volatility in the opposite direction of one’s trade leads to liquidation.
Stop losses represent a hallmark of risk management as they allow traders to calculate and set losses the moment that a position is opened. The mechanism helps traders from needlessly managing positions manually or falling into analysis-paralysis and letting more losses come in before admitting defeat.
For example, let us say that we have a 15x leveraged Bitcoin long position open with an entry price of $32,000. Our strategy and analysis indicate that bullish times are ahead, but what if we end up being wrong? Bitcoin’s price may fall under our entry and the moment it does, we are already at risk of liquidation. Per our calculations, the position will be liquidated as soon as Bitcoin reaches $30,141. How do we prevent that from happening? We set a stop loss.
Where we set the stop loss depends on our risk appetite. A 1% loss equates to 15% after taking into account leverage, which occurs at $31,680. A 2% loss (30%) would set our stop loss order at $31,360. Naturally, stop losses are generally lax when smaller leverage is used. In either case, the order that you are learning about is a prerequisite to ensuring the safety of your portfolio.
A stop loss is the opposite version of take profit (TP) orders. If you have ever used TP, you know that it is possible to adjust them in various ways, like setting complete and partial orders.
A complete stop-loss is exactly what it means. When executed, the order closes the entire position at the selected price level. This is usually done when one believes that his trade is obsolete once the price reaches a certain point.
A partial stop loss means that the position is partially closed. You can have it so that only 25% or 50% of the position closes when your trade is invalidated. This order type is suitable for less risk-averse traders who believe that there is more room for pressure even if the market behaves inversely to one’s expectations. Partial stop losses also come in handy if you wish to place multiple orders at different levels rather than just one.
Trailing stop loss is another advanced order type used by advanced users. The advantage here is that trailing stop losses move along with the price of an asset if it moves in your favour and remains fixed if it does not. This makes it a great method of securing profits at higher price levels if the market decides to retrace at one point.