A stop-loss is a pre-set order that automatically sells your position when the price reaches a certain level. It is your safety net. Without a stop-loss, a small setback can grow into a major loss that undermines your entire strategy.
How does a stop-loss work?
You buy a stock at 50 euros and set a stop-loss at 45 euros. If the price drops to 45 euros, your position is automatically sold. Your loss is limited to 5 euros per share, or 10%. Without a stop-loss, you might not have acted until 35 or 30 euros - if you had acted at all.
The power of a stop-loss lies in the fact that you make the decision at a calm moment, before emotions come into play. When the price drops, you no longer need to think. The system acts for you.
Types of stop-loss orders
Fixed stop-loss
A fixed price level at which you sell. Simple and clear. You determine in advance how much you are willing to lose and place the order at that level.
Trailing stop-loss
A stop-loss that moves with the price. When the price rises, your stop-loss rises with it. When the price falls, the stop-loss stays at the highest point. This way, you protect accumulated gains while letting the trend continue.
Example: you buy at 50 euros with a trailing stop of 10%. The price rises to 60 euros, and your stop-loss is now at 54 euros. The price drops to 54 euros and you are stopped out with a 4 euro profit per share.
Mental stop-loss
Not an actual order, but a level you keep in mind. This only works if you have the discipline to actually sell when the level is reached. Most investors lack that discipline, especially when the price drops rapidly and emotions run high.
Where do you set a stop-loss?
The placement of your stop-loss is at least as important as having one. A stop-loss that is too tight gets triggered by normal price fluctuations. A stop-loss that is too wide does not protect enough.
Commonly used methods:
- Below a support level: if the price historically finds support at 47 euros, you place your stop just below that level at 46.50 euros.
- Percentage-based: a fixed percentage below your entry price, for example 5% or 10% depending on the stock's volatility.
- ATR-based: the Average True Range measures the average daily price movement. A stop-loss at 2x ATR gives the price sufficient room without taking unnecessary risk.
- Below a Fibonacci level: with a Fibonacci retracement, you can place your stop-loss just below the 78.6% level.
Stop-loss and position sizing
Your stop-loss directly determines your position size. The distance between your entry price and your stop-loss, multiplied by the number of shares, is your maximum loss on that trade. That amount should never exceed a predetermined percentage of your capital (many professionals use 2 to 5%).
Read more about this in the article on risk management.
Common mistakes
- Not using a stop-loss. "It will be fine" is not a strategy. Every professional trader uses a stop-loss.
- Moving the stop-loss lower. When the price moves toward your stop-loss, the temptation is great to move it further away. Do not do this. You had a reason for choosing that level.
- Setting the stop-loss too tight. If your stop-loss falls within the normal daily volatility, you will constantly be stopped out of positions that would have been profitable.
- Placing it on round numbers. Many investors set their stop-loss at 50, 45, or 40 euros. Large players know this and "hunt" those levels. Place your stop just below the round number.
Stop-loss for crypto
With cryptocurrencies, a stop-loss is especially important due to the high volatility. The market is open 24/7, so prices can move significantly while you sleep. A stop-loss protects you from unpleasant surprises the next morning.
Keep in mind that during extreme volatility (flash crashes), your stop-loss order may be executed at a lower price than you had set. This is called slippage and occurs more frequently with less liquid cryptocurrencies.
A stop-loss is not a sign of weakness. It is a sign of professionalism. The best investors know not only when to enter, but especially when to exit. The latter is more important than the former.