How to use stop losses effectively

Introduction to stop losses

Whenever you see an advert for a margined financial product such as spread betting or cfds, you are bound to see the risk warning stating that these are high-risk instruments that can result in losses in excess of your initial trading deposit.

While the potential for losses are part and parcel of financial spread betting and cfd trading, the fact remains that there are simple mechanisms for mitigating trading losses and ensuring that you never lose more than a predetermined amount of money on any single spread betting position.

What are stop-losses

We’ve probably all heard the popular stock market adage “cut your losses and let your profits run”. Until the advent of stops, this adage was just another of those wise-cracks that are easier said than done! If only the novice trader could instinctively know when to close a losing position while having the emotional discipline to refrain from exiting profitable positions too early!

A stoploss is simply a tool that allows a spread trader to set the maximum amount of money that he or she is willing to lose on any given trade. Typically, a stop-loss level can be set and changed (if you so wish) at any time while the trade is still open.

Types of stop-losses

There are two key types.

The ‘simple (or ordinary) stop-loss’ is essentially just an indication (to the broker) of where you would like your position to be closed in the event that that market goes against you. However, although your broker would typically endeavour to close out your position at the stated price level, it may not be possible to so if the market gaps through that level. This slippage risk is the price you pay for not paying a little extra to guarantee the stop loss price level.

The ‘guaranteed stop-loss’ removes the problem of slippage by ensuing that your losing position is definitely closed out at the predetermined price level. In this case, you pay a little bit extra (usually no more than a couple of points times your stake) for the added security of knowing exactly what your potential maximum loss is.

Stop losses: page 2