A stop loss has 2 purposes:
- Close a position at the point a trade is invalid
- Pre-define risk in terms of potential $ lost
This article will cover what, why and how to use a stop loss with the above 2 points in mind.
What is a stop loss?
A stop loss is an order that closes your position. If you are long, the stop loss will trigger sell orders to close your position. If you are short, the stop loss will trigger buy orders to close your position.
Depending on the exchange you use, there are multiple types of stop losses. I’ll cover limit and market stop losses since these are the 2 most common on Crypto exchanges.
Stop Limit: When price reaches the “stop price”, a limit order will be placed at the “limit price”
This means there is no order in the order book until price reaches your set stop price.
I’m trading 1 Bitcoin and if price goes below 3780, I believe price will drop further and I want out of my position.
On Binance, this is what it would look like:
When current price reaches 3785, an order to sell 1 BTC will enter the orderbook at 3780.
Stop Market: When current price reaches stop price, automatically close position at market price.
The main difference between the two is, with a stop limit there is potential for your order to be skipped over if price is moving fast . The stop market will make sure your position is closed, even if it is at a less than desired price. If a freight train is barreling down towards you, you don’t want to try picking pennies off the track – you just get out of the way.
Each exchange has different options and they will have explanations of how to use them. If available, use the exchange’s test net to understand exactly how each works. Losing money to user interface confusion happens and it is in my opinion, the worst way to lose money trading.
Why should you use a stop loss?
Trading is a game of probabilities and you will be wrong. When you are wrong and the market does not move in your favor, you want out of the trade as soon as possible to mitigate losses. A stop loss is your safety net for when you are wrong.
Trading without a stop loss is much like a trapeze acrobat performing without a safety net below, 1 slip up and they(your account) could die.
The 1 way every trader will try to rationalize trading without a stop loss
“I know the market is going to move in my favor because XYZ and I don’t want to get stopped out and miss the trade”
This is an example of the certainty effect*. When you have 2 options, the first being a “sure thing” and the second being a chance, your odds decrease from 100% (I know I’m right) to less than 100% (There is a chance I’m wrong). When considering both options, your mind naturally gravitates towards the “sure thing” since it induces more pleasure and blocks out the possible pain from being wrong.
If you trade without preparing to be wrong, you will inevitably fail until you accept the market can do ANYTHING at any time and you don’t ever truly know what will happen
Remember, there is always another trade
A trader should be focusing on their potential losses, their risk, when setting up a trade. In the above scenario the trader is choosing to potentially lose everything versus losing a predefined amount by setting a stop loss. This is a cognitive bias called the framing effect*. When a trader frames each trade in terms of the amount they can lose instead of only gain, it becomes obvious that a stop loss is necessary.
How to use a stop loss
You have decided where you want to enter your position but you’re not sure where to place your stop loss. We discussed the point of a stop loss is to prevent losses once price has proven that your trade idea was wrong. This means there is only 1 logical place to put your stop loss:
The point of invalidation – where your idea is wrong
The reasons each trader takes a trade and decides on their entry, are unique so you have to define the price at which the reasons you took the trade are no longer true.
I am trading ETH and see that price capitulates on high volume creating a low. I then see price make a higher low on increasing buy volume and decide on my long entry.
Since I am entering on the basis that price is making higher lows, if price breaks below both lows I am confident that my trade is invalid and price will head lower.
It is imperative to know WHY you are entering a trade for two reasons:
- Confidence allows you to weather the storm of uncertainty from the time you enter til the time your trade is closed. A lack of confidence leaves you vulnerable to acting on your emotions as price fluctuates and this is not a sustainable way to trade.
- When you can identify exactly why you are entering a trade it allows you to map out exactly where you are wrong, allowing you to easily decide on stop loss placement.
The main reason traders have trouble deciding on stop loss placement is because they don’t know why, without a doubt in their mind, they entered the trade.
I recommend adding these reasons to your trade journal so you can remind yourself why you took the trade and remain confident as price fluctuates. You’ll also be able to track which setups work best over time, allowing you to refine your strategy.
Price returned to my entry point and I am now in a long position.
Since my stop loss is set, my risk is predefined before I entered the trade. I know exactly how much I can lose if I am wrong on this trade. I am comfortable with this amount which gives me the peace of mind to see the trade through until my target or stop loss are hit.
Price moved in my favor and my target was hit!
Common errors when placing a stop loss
Placing a stop loss based on a $ or % value the trader is willing to lose.
Traders can fall into this trap and believe they have successfully placed a stop loss since they defined the amount they will risk, but that is only 1 of the 2 purposes of a stop loss. If a trader sets a stop loss anywhere other than the point of invalidation they are leaving themselves vulnerable to 1 of 2 risks.
- Your stop loss is closer to price than the point of invalidation which runs the risk of being stopped out and price reversing in your favor without you in a position. You were right but you lost money.
- Your stop loss is farther away from the point of invalidation resulting in extra losses than necessary if price moves against you.
When you should not move your stop loss
It can be tempting to move your stop loss once you are in a position and price moves away from your entry in your favor.
A rule to always follow is:
If the point of invalidation hasn’t changed, neither should your stop loss.
Moving your stop loss up too soon can result in getting stopped out of a trade you would have otherwise been able to ride further.
When you should move your stop loss
Moving a stop loss once price has moved in your favor can be a good way to secure profit. Following the rule above, this should only take place when the point of invalidation moves.
Let’s use the previous example but instead of closing the trade we want to keep it open because we believe price will continue to move higher.
Once price moves in our favor a new invalidation level is created. Price broke through $130 which acted as support before the move down and should have acted as resistance on the way up. We now believe if price is to move below $130, our trade idea is invalid and price will continue down further. Moving our stop loss to just below $130 allows us to secure profit if price reverses or allows us to stay in the trade as price continues higher.
Understanding pockets of liquidity to help set your stop loss
When placing your stop at invalidation, consider that other traders may be doing the same thing and move your stop just a little bit lower. This will help you be one step behind the crowd so their stop losses absorb price and yours is not hit.
Stop loss test
Where would you set your stop for this long entry?
Larger players are always looking for easy liquidity in the form of stop orders which when triggered, allow them to increase their position before a move. You will hear this referred to as a stop hunt or raid.
Wherever you do set your stop loss, make sure you are truly comfortable with losing the amount of money if that stop is triggered. If you are uncomfortable with that $ loss you won’t be able to trade with a clear and confident mindset.
-Always use a stop loss. It is better to be sure of a small loss than run the risk of a large loss. There will always be another trade.
-Set your stop loss at the point of invalidation
-Only move your stop loss if the point of invalidation has changed
-Consider obvious areas of liquidity for stop hunts and set yours behind these areas
Position size and measuring risk vs reward(R) will be covered in part 2 of this series.
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* The two effects mentioned above are part of prospect theory introduced(1979) by Daniel Kahneman and Amos Tversky, the fathers of Behavioral Economics. I highly recommend the following book to everyone and even more so to traders:
Thinking Fast and Slow by Daniel Kahneman
And if you become as enthralled with the book as I did, read the following which details their unique lives as friends, Nobel prize winners, military officers and more:
The Undoing Project: A Friendship that Changed our Minds by Michael Lewis