How to use stop losses effectively [2]



A major feature of guaranteed stop losses

From the perspective of financial spread traders, there is a unique feature guaranteed stop losses that is often overlooked. In fact, although there are thousands that claim to teach you how to use stop losses for spread betting, I have not come across a single one that highlights this unique feature.

Essentially, using guaranteed stops transforms the payoff structure of a financial spread bet. One fundamental feature of spread bets and other margined products such as cfds is that while profits can quickly accrue when things go your way, losses can mount just as quickly when trades go wrong and you could end up needing to come up with further funds in excess of initial account deposit in order to cover total losses.

However, this payoff structure of potentially unlimited gains (on long positions) combined with practically unlimited potential losses is transformed to one which is a combination of potentially unlimited gains with limited losses that are predetermined upfront. This transformation means that the spread bet protected with a guaranteed stop loss has a similar payoff profile to a traded option position in the same direction.

So where should you place your stop losses when you spread bet?

There are various ways in which a trader can determine where to place a stop. Whichever approach is used, the aim is the same—to determine the maximum spread betting points that a trader is willing to lose on any given trade and then translate that into cash equivalent.

Nominal cash approach: One approach is to simply use a nominal cash amount based on the maximum loss that the spread bet trader is willing to take on any single position. In this case, the trader simply sets a maximum acceptable cash loss.

Example—say you are about to place a buy bet on a stock trading at £5.00 per share and you intend to take a £2 per point stake. Also, you have decided that you do not want to lose any more than £500 on the trade. Since spread betting is based on movement per point, you need to first translate the £200 maximum acceptable loss into spread betting points. To do this, you simply divide the £200 by the £2 stake. This leaves you with 100 points of maximum acceptable loss. Since you are buying, this means that once the stock falls by 100 points below your entry point, you would have lost the maximum amount that you are willing to lose on the trade. As such, in this scenario, you optimal stop loss level would be 100 points below the current price of £5.00 = £4.00.

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