Limiting Risk With Stop Losses

Ensuring the preservation of your capital is your most important task as a spread better. There is little point in making a great trade today if tomorrow you are going to be wiped out completely. The well known adage advises that to profit from the markets over the long term, you need cut your losses short and let your winners run. But how do we cut losses in practice? Let’s take a look at what a stop loss is, why it is so important and how to use it in your spread betting practice.

What Is A Stop Loss?

When we enter a trade, the market will either go in the direction we want it to or it will move against us. When the trade moves against us it will keep on doing so until we either choose to exit the trade or we run out of margin in our account. Whenever I enter a new trade, I always know up front what my maximum loss is going to be. I enter a stop loss in the market as soon as my initial trade is filled. If the market moves against me and my stop loss is triggered, I am automatically out of that trade.

Why Are Stop Losses So Important?

Stop losses are so important because they take the emotional aspect of trading out of your hands. If instead of placing that stop loss order in the market, I instead monitor the trade each day to see how it is doing, I could find myself in a very uncomfortable position. I could start convincing myself that although that particular trade looks like it is going bad, I am so sure of the validity of my initial opinion that I am going to wait it out a little longer just so that I can be proved right. A “little longer” becomes longer still as the trade moves against me even more. Before you know it the trade has moved against you far more than you ever thought possible and the spread betting company is on the phone to you with a margin call.

How To Use Stop Losses In Practice

You can avoid this emotional situation entirely by placing your stop loss in the market as soon as you place your trade. This way you can disengage yourself from the trade being about how right or wrong you are. Trading becomes far more profitable when it focuses on the price action unfolding on the chart rather than whether or not your own ego needs to be proved right.

So we have covered the concept of a stop loss, but what is the right price to use for setting the stop loss? Personally speaking, I use the following approach. When you are entering a new trade you are doing so based on an opinion of where price is going to go in the near future. You enter the trade on confirmation of that opinion, so you should exit the trade when that opinion no longer holds true. Use the chart to tell you the price at which your opinion is wrong. Don’t be attached to that opinion and let the market guide you.

For example, if my set up is that I go long when a trend pulls back and then resumes, I will enter the market when the trend starts again so I should exit the trade if that trend fails. My stop loss therefore goes just beneath the swing low of the retracement. If I am trading a long breakout through resistance, I put my buy order to enter just above the resistance level. Once in that trade, my sell stop loss sits just below the resistance level that has been broken.

Note: Remember that a normal stop loss orders do not protect you in the event of a market gapping so do consider a guaranteed stop loss for added protection particularly for volatile markets.