Stop Loss in Trading

January 27

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Posted by: Lorraine Longman,
 January 27, 2021

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Is Stop Loss In Trading Really Necessary?

Traders are taught to set stop loss for every single position they open. This measure is presented as a surefire way to limit losses. But is it the only method available? Alternatives to stop loss trading exist, but they are mostly suitable for institutional players. Management of risk is the primary, albeit not the only, motivation for the stop-loss concept in trading. 

Yes, you need a stop loss, unless you want to see your trading account wiped out. Do not try to outsmart the market – it is impossible. Play by the rules. In order to succeed, you should take only calculated risks. So, what is stop-loss in trading on platform Olymp Trade?

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Stop Loss In Trading

What Is Stop Loss In Trading?

The stop loss is your guardian angel, and this is hardly an exaggeration. The market is beyond any trader’s control, and it may get turbulent at any moment. However good your foresight, your predictions cannot always be right. 

Think of factors that may cause a market frenzy. The sheer number of potential drivers is humbling. What if there is a surprise political announcement while you sleep? Accept the fact that there will be unknowns that can make a dent in your budget unless you limit your potential losses smartly. 

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Classic Example

Consider the actions of the Swiss National Bank in the early 2000s. The institution chose to keep the EUR/CHF pair at 1.20 and not let it drop lower. Back then, the Swiss franc was estimated to have become too expensive. Institutional traders were buying and selling large volumes every time the pair approached the level. This was easy money at the time. 

Eventually, on the 15th of January 2005, the central bank abruptly terminated the peg, sending the price into free fall. The value nosedived, falling several candles in fractions of a second. Around the world, retail traders without a stop-loss saw their balances wiped clean. 

For example, it was true for Americans who bought and sold the EUR/USD pair relying on the Swiss National Bank’s protective policy. If you had been in their shoes, wouldn’t this situation have taught you something? Some of these people were trading on leverage, so they lost more than their deposits. Moreover, as orders could not get filled in a timely manner, many became indebted to their brokers.

You may argue that such extreme situations are rare. Still, losing 120 pips at night is common for pairs like GBP/JPY. Stop loss is not only an instrument against disasters. It is meant to protect your funds when your analysis is inaccurate. And let’s be honest with ourselves – flawed analysis is an integral part of the game.

How to Use Stop Loss

How to Use Stop Loss in Trading

How much can you afford to lose on a trade? The rule of thumb is to put no more than 1% of your capital at stake per trade. This is the basics of how to use stop loss in trading. The trading software should allow you to set this value for every trade. There is no shortage of information on how to set stop loss in intraday trading and other strategic scenarios. 

If you make a mistake, stop loss will protect you from losing too much. You may still enter the market another day and succeed. Sooner or later, your forecast will be proven wrong. 

At the same time, if your guess is right, it is acceptable to move the stop loss in order to lock in gains. There are two conditions: stop-loss may be touched after a certain period of time, or after the trade has moved in your favor significantly. Learn how to calculate stop loss in intraday trading and protect what you have. Is it possible to use Stop Loss on Olymp Trade or IQ Option in our comparison? 

Alternatives to Stop Loss in Trading

So, what do institutional traders do that allows them to forego stop loss? Major players may use options for protection purposes. These securities limit the effects of currency fluctuations, but they are too complex for most retail traders. The latter should rely on stoploss and accept their failures as soon as they happen.

Suppose your stop-loss is set at 1% of your balance, which is the highest recommended limit. What if you lose? The damage will not be devastating. However, reliance on hope without a stop-loss may cause you to lose so much that recovery will be impossible.

Now, let’s see how options work. Imagine you are buying EUR/USD. At the same time, you may purchase a put option for the same pair. If the market moves against you, and the trade brings a loss, the option allows you to recover at least some of it. Otherwise, the instrument expires, and its price is a sunk cost.

In practice, options are much more complicated than this. Therefore, if you want to protect yourself on a tick by tick basis, you need to consider other methods – i.e., stop loss.

Alternatively, you may take a trade in the opposite direction with the same broker. This is a possible, but hardly lucrative scenario. Only one of those trades will be profitable, while the second one will inevitably result in a loss.

You need to understand that losses are not disastrous when they are controlled. You will be able to compensate for at least some of them in the spot market. Overall, stop loss in trading is indispensable.

Alternatives to Stop Loss in Trading

The Bottom Line

Never ever trade without a stop loss. No circumstances can justify doing otherwise. Even though extreme situations are rare, they can happen during your trading career. There’s always better to be safe than sorry, right? Learn how to apply stop loss in trading, and you will never lose more than you can afford. 

The only way to become a successful trader is to accept your losses and keep them under control. There is no magic solution. You cannot trade without losses, but you can limit the damage and recover quickly.

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