A: The one thing that people fear most about trading the stock market is losing all their money and stop loss orders are useful to put a cap on losses.
First what is a stop loss order: A stop is an instruction to deal at a less favourable level than the current price. The objective is to limit your loss, or stop your loss at a certain level.
The leverage that spread betting provides allows for great opportunities but can also be equally dangerous; this is because gains and losses are amplified and although this works well when the market is moving in your direction it can be futile if the trade goes wrong and you are over leveraged. Risk management is not about what happens when trades go right but it is what happens if a trade goes wrong. Using stop losses is key to a successful spread betting career...
Stop losses protect you from taking big losses should the market move against your position. For instance if you took a long position on Marks & Spencer (LON: MKS) at 263p you would place the stop below 263 to sell your stock should the price go down. This limits your losses should bad news strike or the stock price really tanks out (some stocks can drop more than 50% in a day on bad news). The other thing a stop loss order does is to provide you with a set loss amount that you can account for. Let's say you set your stop at 250p. The most you can lose is 13p a share no matter what happens (plus slippage of course).
One of the most common errors that new traders make is to fail to pre-define risk i.e. do not use stop loss orders and even more gravely they tend to add to losing positions. When you buy into a margin position, you should know exactly the maximum amount you are ready to risk if the trade turns against you. You should have no ambiguity, no uncertainty, and no wavering about the need to cut your losses short and the only way to have pre-defined risk is to use stop loss orders. Keep in mind that without a stop loss, your trade will keep bleeding money while adding to your losing position is akin to pouring salt into your wound. If you really believe in the trade, let it be stopped out but continue watching it, and then if the high probability setup returns, you can always have another go at it with stops.
So always use stops, and don't leave the stops in your head (this game is really all about your mind!) - you need to place them in the market. Stops in your head do not really limit the risk as markets can gap or you may end up changing your mind when time comes to execute your stop loss! A stop loss order should always be set up at the same time that any trade is planned or entered.
Disciplined stop loss sell orders are the key to long term trading success and experienced traders always uses stops to define risk and protect capital.
P.S. Now this is all very well in theory, but you have to be aware of slippage and gaps. Gaps when trading refer to instances where today's market opening price for an instrument is different to the closing price from the day before for that instrument. For instance the closing price on Monday for Next (LON:NXT) may have been 1218 pence and the stock might open on Tuesday at 1150 (this results in a gap from 1218p to 1150p). Gaps occur either because their is a powerful reaction to corporate events or because the market was unable to adjust to news that occurs outside market hours. Indices and currencies are very much less likely to gap than shares as they are a combination of more than one company so the impact of a stock-specific event is mitigated and thereby less likely to result in a gap. In such instances unless it is a guaranteed stop loss, if you had a normal stop loss order on say Next (LON:NXT) at 1190 and the price opens at 1150 Tuesday you will be closed down at that price (1150) under a rule called 'best endeavours'.
'The simple fact from our statistics is that clients have more winning trades than losing trades but the ones who lose do so because their losses are bigger than the winning trades and this is not just in spread betting but trading financial markets using margin products. It's much, more difficult than people imagine to control losses.' Angus Campbell, Head of Sales of Capital Spreads
A: Stop losses work as part of a structure. They are great as once setup they remove you from the equation.
Say gold is trading in a range between $715 and $739. As Warren Buffet correctly says 'no one rings a bell at the top' or indeed the bottom.
So let's say you put on an order...
If gold hits $720 BUY...
If that executes
1) Then an automatic stop loss of $715 is created (why?...because if Gold goes that low it's fallen out of its range and will decline to the next support level) .
2.) A limit profit sell order at $730 is created.
You could then go and leave it to its own devices, go for a walk, have a cup of tea, hump the girlfriend...etc.
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An alternative might be BHP Billiton hitting a record £1750.00, say I'm a cash investor and think the stock has overrun.
So I put in a sell order with a stop loss at £1775.00 (because maybe I'm wrong and maybe there won't be profit taking).
And a limit profit order of 1700.00 because I believe the stock will rally, and has support at this level.
Now I've locked in a profit, and if I'm right I'll be overall neutral on the sell-off, but in effect make a second gain when BHP eventually rallies back to £17.50.
True, there has to be something driving an asset and mostly this follows a logical pattern. However, in those instances where behind the scenes something dramatic happens, the market can slip wildly when it should rise, and vice versa. These are the positions in which stop losses are drastically important. It's all very well making a decent profit on most of your bets, but if one of them cleans you out completely because of a points movement you couldn't even begin to predict, then you might as well never have started at all.
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