Trading in the financial market involves various risks. That’s why traders came up with different ways and solutions to protect their accounts from being wiped out by sudden volatility spikes. The most popular way is using stop-loss and take-profit orders.
What are stop-loss and take-profit
Stop-loss and take-profit are limit orders. Through them, the trader tells the broker at which price he wants the trade closed. Placing a take-profit order allows the trader to lock in his profits when the asset is moving in the desired direction. Stop-loss order closes the position if the price goes against the trader, i.e. prevents further losses.
How to set Stop-loss
There is no single rule which could be used to determine the exact stop loss level since the market is unpredictable. Usually, the choice of the level depends on the skills, experience of the trader, as well as his risk tolerance: some can afford to lose 100 pips, while for others, even a loss of 50 pips would mean a fiasco. Nevertheless, novice traders should follow some basic rules:
for BUY orders, the stop loss should be set at the local minimum, and for SELL transactions – at the maximum value, i.e you need to set it exactly along the line of the largest candlestick, which was formed right before opening a position. This option is quite simple, but these stops are deliberately knocked down by large market participants. Therefore, we recommend setting the level a little further.
- set by the past closed candlestick – around to the highest high or the lowest low. This option is used in intraday trading.
- determine the stop-loss using indicators. For example, Bollinger Bands channels, moving averages, etc.
- place stop loss order based on volatility, for example, using the average true range (ATR) indicator.
- determine stop loss based on important support and resistance levels. You can either find these areas on the chart yourself or use indicators.
How to set Take-profit
In this case, there are much fewer rules, since no one knows how many points the price will actually pass in the direction the trader needs. Therefore, traders usually adhere to the 1: 2 or 1: 3 ratio. So, if the limit order is set at 15 pips, then with the 1: 2 ratio, the profit will be set at 30 pis.
When determining the take-profit level, it is important to take into account the average daily volatility of an asset.
Advantages of limit orders
- They can hedge you against market risks and technical errors.
- The limit order guarantees that the trade will be closed at the predetermined level.
- They promote compliance with the trading system.
- Setting stop-loss and take-profit levels keeps you more disciplined.
Disadvantages of limit orders
- As a rule, traders place limit orders at specific levels. This is well known to market makers who seek to knock out a large number of small participants from the market.
- Sometimes when a trader has set take-profit levels, he loses flexibility in situations where it is necessary to make non-standard strategic decisions. One of the main trading rules says that you should let your profits run. When you place a take-profit order, your potential profits are limited.
In spite of these disadvantages, we believe that limit orders can prove to be very useful. With proper money management and a solid trading strategy, limit orders guarantee profit, and reduce the psychological pressure and stress of a trader.