Using stops and limits to manage risk
In this lesson we’ll take a look at how you can use both stop-loss and stop-entry orders to add discipline to your trading – minimising your risk, aiding planning and locking in running profits.
Using a stop-loss
Before opening a position, think about the maximum you are prepared to lose on that trade. Remember, if you want a healthy risk-to-reward ratio you need to control the amount of risk on each trade – which you can do by setting a stop-loss (a ‘normal’ stop in our platform).
As a guide, many traders wouldn’t risk more than 1% of their account equity on a single trade, and you should never risk more than 10%. By limiting your risk to 1%, you’ll still have at least 99% of your account equity if the trade doesn’t go your way.
Once you’ve determined what percentage of your capital you’re comfortable risking on a trade, you can figure out where to put your stop.
Imagine you want to open a long position on ABC plc, priced at 983, for £20 per point.
You have £50,000 available to deal on your account, which you can see in the balance bar at the top of the platform.
You only want to risk 1%, so £500, of this equity. At £20 a point, this means you’ll need to close your position if the market moves more than 25 points against you. By adding a stop-loss at 958 – 25 points below the current market price – you know that your position will automatically close out if the market reaches your risk threshold.
You can see both the level at which your stop will close you out, and the amount you’ll lose, just below the box where you enter your stop.
By putting a stop-loss on your trade you automate closing at a predefined level, removing any temptation to leave the position open for longer in the hope that the market will bounce back.
It’s also important that you commit to a stop once you’ve placed it. A common mistake traders make is to set a stop, only to keep moving it further away from the current market price to prevent the trade being stopped out – eventually losing as much money as if they hadn’t applied a stop at all.
Guaranteeing your stops
With all orders there is a risk of slippage – during times of volatility it might not be possible to fill a basic stop-loss at exactly the amount you set. By setting a guaranteed stop you remove this risk, only paying a small premium if the guaranteed stop is triggered.
You can set guaranteed stops easily in the deal ticket. Just select ‘guaranteed’ from the ‘stop’ drop-down.
Using a stop-loss to lock in profit
Stops aren’t just for protecting against risk – you can also use trailing stops to lock in your profits at the same time.
Trailing stops automatically adjust to market movement, meaning they follow your position if the market moves in your favour – and close the position, locking in profits, if the market then moves against you.
You can choose a trailing stop in the deal ticket – just select ‘trailing’ from the ‘stop’ dropdown.
Say you open a long position on the FTSE 100 at 6255. You set a trailing stop at 6245 – 10 points away from the current market price, and you also set a ‘trailing step’ at a distance of five points. The step is how far the market needs to move to activate your trailing stop.
The FTSE 100 moves by five points to 6260, the trailing step is triggered and your trailing stop starts to follow the market price – maintaining the 10 point distance.
If the FTSE 100 were then to rise to a high of 6271, but then fall by 40 points, your trailing stop would’ve fixed at 6,260 (10 points away from where the five-point step last kicked in, at 6270) and your position have been closed out, earning you a five-point profit you would have missed out on with a normal stop-loss.
As your stop moves closer (or even past) the opening price, your risk-to-reward ratio improves.
Remember that trailing stops aren’t guaranteed, so they can be subject to slippage.
If you’re watching a position and the market is moving in your favour, you can also lock in profit by manually moving a basic or guaranteed stop to follow the market. You can do this by editing your stop in the ‘positions’ panel:
Or by manually dragging your stop level on a market’s chart:
Remember, while it’s ok to move a stop closer to a market that’s moving in your favour, it’s not good practice to move a stop away from a market that’s moving against you.
Using stops to open
You can also use stops to open positions – we call these stop-entry orders. They’re a good tool when you want to take advantage of market momentum and enter a market once a trend has been confirmed.
You can set them in the ‘order’ tab of the deal ticket. You’ll know that you’re setting a stop-entry, because the button you click to place the order will automatically update with your order type dependent on the opening level you choose.
XYZ Ltd is currently trading at 498.50, and based on your analysis you’re confident that if the price hits 500, it will continue to rise. So you set a stop-entry order to open a long position at 500.
XYZ Ltd does hit 500 and continues to rise. Your stop-entry order opens your position at 500 and you profit from the upward market movement.
Stop-entry orders are a good tool if you think you might be tempted to act impulsively on market movement, even when your analysis suggests you should wait for a particular trend to be realised before taking your position.
Incorrect2% of your account equity is £420, so at £10 a point you want to set your stop-loss order 42 points away from the current market price. Because you want to take a short position, this needs to be above the current market price.
IncorrectIf you risk 2% on this trade with a 1:2 risk-to-reward ratio you would be looking to make 4% of your trading capital if the trade goes in your favour.
- Work out where to place your stop by defining your risk threshold before you enter the trade
- Don’t be tempted to move a stop-loss once you’ve set it
- Set trailing stops to lock in profit, and guaranteed stops to prevent slippage
- Use stop-entry orders to enter a trade when a market trend has been confirmed