What is a stop-loss trading strategy and how does it work?

Do you trade safely?

Trading with a strategy in mind is a very important factor in determining if you are going to generate gains or losses. But having a good trading strategy is not a straightforward task and it does not guarantee you a 100% chance of success. As nobody can time the top or the bottom of the market, you should implement risk mitigator tools that will protect your back in case your trading steps on a crack.

By a crack, we mean the market moving inverse of the direction that you intended it to move towards. In other words, you are shorting a cryptocurrency but the market is growing, or you are going long on a crypto and the market is moving downward.

For you to avoid incurring big losses, implementing stop losses into your trading strategies is a vital factor for your long-term success. It also increases the average return of a trading with crypto bot. The stop loss (or protective stop) is the price level at which the investor will prefer to close out his position, in case of a loss. It also designates  sell orders (in the case of a buy) with a stop loss threshold at these stop levels.

In simpler words, a stop-loss defines the maximum acceptable loss for the investor, and can be chosen according to graphical criteria (support, resistance, moving average, etc…). It is an essential element of money management.

Are you aware of the importance of a stop loss?

Trading without stop losses is really risky and can cost you a lot in cases where the market caught you unguarded. Stop losses can set the difference between your whole position being liquidated and losing only a chunk of your funds. Let’s take a look at the different factors that make trading with stop losses an important aspect of trading in general:

  • They are useful if you are not available for a long time.
  • They limit losses (which can be significant when trading with leverage).
  • They are free.
  • They prevent loss aversion by closing the position automatically, rather than tying up losing trades.

What are the different types of stop losses?

Fixed Stop-Loss Order 

It refers to when an investor places a fixed stop-loss order and their predetermined price is hit. It may also be time-based, a technique that is frequently used by investors who want to pause at a predetermined time before making a profit and moving on to the next trade. 

Trailing Stop-Loss Order

An investor is given net profit and protection by a trailing stop-loss order, which also acts as a barrier against an unanticipated downward trend in the asset price. This order is based on a percentage of the overall price and includes a sell instruction in the event that the market falls below the predefined amount. On the other hand, the trailing order promptly changes to reflect a general gain in market valuation as the share price rises.

How can you use stop losses in your trading strategies?

The most important principles in trading can be expressed in just a few words: limiting risks and maximizing profits. Experienced traders understand very well the importance of stop-loss strategies but are faced with a common problem that happens a lot, which is when the market is going against the order just far enough to trigger the stop-loss and then reverses in the direction of the original trade.

This can be very frustrating and cannot always be avoided, which brings up the importance of setting up a stop-loss order at the right levels to give enough room for the order to go in your favor. 

You can use chart-based methods to determine at which level you should set your stop-loss order, and to do so, you should know about support and resistance for a given asset price. Support happens when a downtrend will likely pause due to a concentration of demand, and resistance happens when an uptrend will likely pause temporarily, due to a concentration of supply. The two lines look like this when plotted on a chart:

Let’s now take a look at how to place your stop-loss orders with the chart below:

So, in case you are day trading and want to go long on this asset, you will ideally wait for the asset’s price to go down near the support level to buy, while setting up your stop order to be below the support level. Setting up the stop-loss order to be below the support level at $0.29, for example, will give enough room for the trade to eventually go in your favor rather than being triggered by push-through prices until the trend reverses. The same thing should be done with short positions using the resistance level instead.  

Another way that traders use to determine at which levels to set up their stop losses is by looking at the annual volatility of an asset, especially in forex trading. This annual volatility is then divided by the square root of the time to give you the daily volatility. An example of this, supposing you have an annual volatility of 12% on a given asset: there are 256 trading days in a year, you take the annual volatility and divide it by the square root of 256, which is 16, giving you the result of 0.75%.

Using the 0.75% you obtained, you can calculate how much it represents below the support level while adding a security margin and setting up your stop-loss accordingly.

Final thoughts

Stop-loss orders should be used by every trader to mitigate risks and avoid funds liquidation. They can also be used with trading bots to set up a safe floor and limit eventual losses. BitLQ app, for example, is a platform providing its users with trading bots and the option to set up stop-loss orders, which can allow you to automate your trades without worrying about your funds being liquidated. 

Author: Kong Lu

Certified blockchain and front-end developer, contributor at www.scammerwatch.com