In the context of trading, risk refers to the probability of losing money or trading capital. Both novice and professional traders are exposed to this risk and experience losses when trading. Risk always will be there, and the inevitability of trading losses requires us to evaluate risk not just by asking the question, “What can I win?” but first and foremost, “How much can I lose?”
Managing risk and controlling losses is essential to any profitable trading plan. While we tend to be optimists and focus on setting appropriate profit targets, we must dedicate more attention to determining acceptable losses, because you can’t win if you are knocked out of the game.
A stop loss is an order to close out a losing position at a predetermined level, thereby limiting losses on any given trade. Of particular challenge is finding the level that protects against large losses while giving trades enough room to become profitable. There are a variety of methods that traders can employ to select stop loss levels, including setting a specific dollar value, risking a percentage of trading capital or using technical indicators.
Stop loss 101
A stop loss is a simple limit to how much capital a trader is willing to risk on any one trade. It can be employed with both long and short trades. In the case of a long trade entered with the intention of profiting from a rising market, an initial stop loss would be placed at a price level below the entry price. For a short trade, where traders attempt to profit from falling prices, an initial stop loss would be placed at a level above the entry price. In either case, the purpose of the stop loss is to close out a losing trade at a predetermined level to avoid more significant or even catastrophic losses.
Investors may use stop losses to protect against adverse price moves because it would be impractical to watch a long-term position on a minute-to-minute basis. Active and short-term traders, however, are not off the hook for setting stop losses.
Even if a trader is glued to his or her monitor for every second of a trading session, markets often move faster than orders can be entered. Because of this, prices could move quickly to and beyond an acceptable loss limit. Placing an order for a stop loss can prevent such runaway losses from occurring. However, where that order is placed relative to the current market price is not always an easy decision. And there is no guarantee you will be executed at your price, particularly in volatile markets.