Stop loss and trailing stop loss

 

Stop Loss

A stop loss is an order you place with your broker to sell an asset if its price reaches a specific level. The purpose of a stop loss is to limit your potential loss if the price moves in an unfavorable direction.

How it works:

1. You buy a stock for USD 100.
2. You want to limit your loss to a maximum of USD 10 per share, so you place a stop loss order at USD 90.
3. If the stock price falls to USD 90 or lower, your stop loss order is automatically triggered.
4. Your broker will then sell your shares at the best available price in the market. Note that the execution price is not always exactly your stop loss level, especially in fast-moving markets.

Key points about stop loss:

• Fixed price level: You specify a particular price level at which the order should be triggered.
• Limits losses: The main purpose is to protect your capital from significant downturns.
• No guarantee of execution price: In volatile markets, the price can rush past your stop loss level, and your order may be executed at a worse price.
• Can be triggered by temporary dips: If you set your stop loss too tight, it can be triggered by normal market fluctuations, even if the long-term trend is still positive.

Trailing Stop Loss

A trailing stop loss is a more dynamic type of stop loss order. Instead of being set at a fixed price level, it "follows" the price as it moves in your favor. If the price reverses and falls back by a certain amount (either a fixed amount or a certain percentage), the sell order is triggered.

How it works (example with a fixed amount):

1. You buy a stock for USD 100 and place a trailing stop loss of USD 5. Your initial stop loss level is then USD 95 (USD 100 - USD 5).
2. If the stock price rises to USD 110, your stop loss level is automatically adjusted to USD 105 (USD 110 - USD 5).
3. If the stock price continues to rise to USD 120, your stop loss level is moved to USD 115 (USD 120 - USD 5).
4. If the stock price then falls to USD 115, your sell order is triggered. You have then locked in a profit of USD 15 per share (selling at USD 115 minus buying at USD 100), while protecting yourself from a larger decline.

How it works (example with a percentage):

1. You buy a stock for USD 100 and place a trailing stop loss of 10%. Your initial stop loss level is then USD 90 (USD 100 - 10% of USD 100).
2. If the stock price rises to USD 110, your stop loss level is automatically adjusted to USD 99 (USD 110 - 10% of USD 110).
3. If the stock price continues to rise to USD 120, your stop loss level is moved to USD 108 (USD 120 - 10% of USD 120).
4. If the stock price then falls to USD 108, your sell order is triggered.

Key points about trailing stop loss:

• Dynamic price level: The stop loss level automatically adjusts upwards as the price moves in your favor.
• Locks in profits: Helps to protect your earned profits while allowing for continued upside.
• Flexibility: Can be set as a fixed amount or a percentage.
• Good for trends: Works particularly well in markets with clear trends, where you want to stay in the position as long as the trend holds.
• Can also be triggered by volatility: Just like a regular stop loss, a trailing stop loss can be triggered by sharp, but temporary, declines.

In summary:

• A stop loss is a static safety measure to limit losses at a given price level.
• A trailing stop loss is a dynamic safety measure that adapts to price movements to both protect profits and limit losses.

The choice between a regular stop loss and a trailing stop loss depends on your trading strategy, your risk tolerance, and the market conditions.