Applying a Stop Loss
A stop loss is an essential tool in the spread betting punter’s armoury. Stop losses enable the punter to limit the downside if a market moves against them. Unfortunately they sometimes fail.
To explain the stop loss, assume you were to buy the daily spread on the FTSE 100 at 5760-5770 and the market fell to 5700 by lunchtime. At £1 a point your loss would be £70.
However, if you set a stop loss at 5730 the bet would only lose £40 because the spread betting company would close your bet at 5730. The only disadvantage is you would miss out if the market subsequently rallied.
However, stop losses do not always provide a guarantee. Sometimes financial markets move so violently that they create what is called a “gap” which can mean you lose more than your stop loss would suggest. A good example of this is what happened with retailer Next in January.
On January 3 Next shares closed at £15.23. Many Finspreads clients had sold the spread in anticipation that the Next share price would fall and had kept their bets open overnight.
Unfortunately for them, on January 4 Next produced a trading statement nothing like as bad as the market had expected and the company’s shares opened at £15.87.
That creates the sort of gap that could destroy a stop loss. Let’s assume our punter had sold Next for £2 a point at, say £15.23 but decided to put a stop loss in place at £15.40. That should mean that if the shares were to rise, their bet would be closed at £15.40 and they would lose only £34 (£2 a point times 17). However, because the shares opened at £15.87 the stop loss would not have had a chance to kick in (because of the gap) and the bet would have loss 64 times £2 or £128.
Some financial spread betting companies will, however, allow clients to take a “guaranteed” stop loss. In these circumstances, any loss created by the gap is borne by the spread betting company.
However, there is a premium to pay for the guarantee. For FTSE 100 stocks, premiums are 1pc of the value of the share times your stake. So, for example, with the Next bet it would have been 15.23p (1pc of £15.23) multiplied by the size of your stake. For bets on the FTSE 100 index, it is twice the size of your stake.
Angus Campbell, Finspreads’ market strategist, said: “Clients have to decide whether placing a guaranteed stop loss is worth paying the small premium. We offer the facility across most of our popular products and find clients like to have the extra protection, particularly in markets such as the Nikkei or currencies.”
Application of Orders to Spread Betting
>> Limited Risk Bets
An investor can chose to protect their bet against extreme adverse movements by setting pre-determined stop loss levels. If the instrument falls below/rises above these levels the bet is automatically closed at the level of the stop loss. Spread betting companies charge for this security in the form of wider spreads.
>> Stop Loss
This works in much the same way a limited risk bet, except the closing trade is not guaranteed to be executed at the stop loss level.
>> Limit Order
The opposite of a stop loss. This is a pre-determined level at which a profit is taken.
Here is a description of the kind of orders you can place (this information applies primarily to stock trading) and how they affect an execution.
# Market Order:
A market order will typically assure you an execution, but not a specific price. When you send a market order, you ask it to be filled at whatever price is available when your order reaches its destination. In a volatile market, the fill price can be substantially different from the price that was quoted.
# Limit Order:
A limit order is an order to buy or sell a stock with a price restriction. A buy limit sets the maximum price you are willing to pay, and a sell limit sets the minimum price at which you are willing to sell. It guarantees you a specific price, but it does not guarantee you an execution.
For example, you may wish to purchase a stock that is currently quoted at 15 bid, 15 ¼ ask, but you do not want to pay more than $14. If you place a limit order at $14, it will be filled only if the price drops to $14 or lower and there are no orders ahead of yours. If the stock continues to trade at its current quote, you will not receive an execution.
# Stop Order:
A stop order is an order designed to protect a profit or guard against a loss. Although it does not work very well in all conditions, it can be an effective strategy in different situations. When placing a stop order, you specify a stock price that, when reached, converts your order to a market order.
For example, you may have purchased XZY stock at £40 and it is now trading at £60. If XZY drops to £50, you want to sell the stock. You can place a sell stop order at £50, and if the stock trades there, your order becomes a market order to sell. The risk with this type of order is that once triggered, your order can be filled at any price because it is a market order.
# Stop Limit Order:
A stop limit order is a variation on the stop order. It works in a similar fashion in that it is triggered once the stock hits the stop price, but instead of becoming a market order, it becomes a limit order at the price that you select. Limit orders in a fast market will reduce your risk of receiving an unexpected execution price. What’s more, a limit order allows you to place an order at the price level you’re almost comfortable with when buying or selling a security. Although a limit order does not guarantee that your order will be executed, it does guarantee that you will not pay a higher price than you expected.
For example you want to limit losses on a stock that you purchased at $50. You enter a stop limit order at “$40 Stop $39 Limit”. Once the stock trades at $40 or below, your order becomes a limit order to sell at £39. This will ensure that you will not sell at an extremely low price if a stock price opens drastically lower. However, you will still own the stock, since the order was not executed.
Each of the above orders has its pros and cons. You should pick the order that is best for your situation and considers current market conditions.
