Gone are the days when the only avenue of investment open to the average person on the street was stocks and shares; now, there is a multitude of markets for both professional and amateur traders to pick from.
Whilst it is possible to make a significant profit from trading, there is also the strong likelihood that heavy losses will occur. For investors who are just dabbling on the side, one big loss could be enough to wipe them out for good. The golden rule of trading is that you should never invest money you cannot afford to lose, but nevertheless, protecting against a big loss is a good strategy.
Being Human
No position should ever be opened without a clear idea of what the exit point will be. This should be decided in advance because trading on gut instinct is one of the easiest ways to lose a fortune. The human psyche is one of the biggest barriers that must be conquered in order to succeed.
It can be very tempting to keep going if you are winning to maximise profits but it can also be equally difficult to quit if you have suffered a loss. One of the biggest mistakes novices tend to make is clinging on to a losing position in the hope the market will swing back in their favour. The good news is that there are tools available to help investors minimise losses and collect gains from winning positions. The really good news is that many brokers offer them for free.
A stop loss is an order that closes the position automatically once a certain level is reached. This provides the trader with the comfort of knowing any losses will be limited to the amount specified, even if they are not actively monitoring the market. A stop loss can be set at whatever level the trader desires but it is important to remember the position will automatically be closed as soon as the market touches the specified point, even momentarily. Setting the stop loss too close to the opening position could mean a potentially profitable trade gets cancelled just because of normal fluctuations in price, rather than a true downward turn in trend.
How far you set the stop loss will depend on a few factors. Firstly, the average fluctuation of the stock should be checked and the stop loss set in excess of this. However, this does not mean you should take risks you cannot afford. If the average fluctuation on the trade you want to place means potentially accepting a loss that is high compared to your account balance, perhaps this isn’t the right trade to make.
How long you plan to hold the position open for will also have a bearing on how low you set the marker. A longer term trade will need to be able to ride out mini troughs along the way, which will be heavier than normal fluctuations. Therefore, shorter trades will be more likely to have a stop loss set higher.
A stop win works in exactly the same way as a stop loss except that it is designed to collect profits once a trade reaches an acceptable level. It may seem pointless to close a position that is doing well automatically, but the market can quickly turn and change a win into a loss.
Before placing the trade, you simply decide at what point you would be willing to accept the gain and where you think the resistance level may lie. This is effectively the tipping point where the market could perform a retracement.
Don’t Slip
Both stop losses and stop wins mean a trader does not have to remain rooted to their PC whilst the position is open, as having automatic closing points provides peace of mind. However, there is one thing every trader should be aware of, namely slippage.
In a market that is swinging rapidly, several sell orders may stack up and this means that although the position may be closed, there could be a brief delay until the stock is sold on. This means there could be a few points difference from your specified stop loss or stop win and the actual selling price; this is known as slippage. Some brokers offer guaranteed stops where slippage is not passed on to the trader, but frequently there is a premium for this service.
Stop wins and especially stop losses are essentially free insurance for investors and with the option being free with virtually every broker, it is foolish not to take full advantage to protect your money.