Crypto Trader: A Beginner's Guide To Adding A Stop Loss
Perhaps you already know that the crypto markets operate day and night, make it difficult for small traders to keep track of multiple deals. Some cryptocurrency pairs are also highly volatile and can experience massive price changes in a twinkle of an eye. Stop-loss orders come in handy in enabling traders to keep track of price changes and help protect their investment.
In this article, we will discuss the stop-loss order, and why you need to use it. We will cover the following subtopics:
- What is a stop-loss order?
- Types of stop-loss
- Why you should not trade without a stop-loss
- Tips for better stop-loss placement
- Common mistakes about stop-loss orders
Before we dive in, please note that this info primarily applies to traditional crypto exchanges (e.g. BitMEX) and NOT to BitPrime's retail or OTC platforms. This information is provided to teach you about other trading options and terms you are likely to come across in the crypto-world.
What is a Stop-Loss Order?
A stop loss is an automatic order you add to your trading position to exit the market should the prices of the asset you are trading reach a certain level. The stop order is designed to lock in profits as well as protect you from excessive loss should price action go against your trade.
Here is an example of how this works
Let’s say you own a cryptocurrency asset that you bought for $100. You are expecting the asset to go up to maybe $140 in the next few weeks. You, however, don’t want to make a considerable loss should the market turn downwards.
You, therefore, direct your broker to set a stop loss of $80. If the cryptocurrency’s price rises above $100, you will gain the profit. However, if the price goes down to $80 or less, your position will be closed automatically.
Types of Stop-Loss Orders
There two basic types of stop-loss orders: the hard stop-loss order and the trailing stop-loss order.
Let’s look at each of them separately.
The Hard Stop-Loss Order
In this stop-loss order, your trade is automatically closed when the price action reaches the stop-loss. Your assets are sold at the market price. The hard stop-loss order is mostly used to minimise the loss on a losing trade.
Trailing Stop-Loss Order
Like its name suggests the trailing stop loss order ‘trails’ the price action as market prices move in your intended direction. In other words, a trailing stop loss will serve as good as a hard stop loss in case the market prices are unfavourable. But, if the market prices are favourable, the stop loss will move incrementally in the same direction (helping you lock in profits).
When using a trailing stop loss, you manually choose the distance you would like to maintain between the trailing stop loss and the price action. For instance, you can set your stop loss to trail 100 pips behind the price as the market moves in your favour. Should the market reverse, the trailing stop remains still.
Why You Shouldn’t Trade on Exchanges Without Adding a Stop Loss
A stop-loss order is one trading component that every trader should never forget to use. Here is why it’s important and why you should never enter a trade without placing a stop loss.
· It helps you determine position size
Once you have determined the stop-loss price level for your trade, you can easily figure out the potential loss by calculating the distance between your entry and the stop loss. You then use this information to identify the position size.
· A stop-loss order defines the worst-case scenario
A stop-loss order ensures that your trade is automatically closed at your chosen level. This gives you the freedom to determine how much you are comfortable with losing on any particular trade. With a stop loss, you never get surprises, and you only risk what you are willing to lose.
· A stop-loss order helps you define your risk-reward ratio
The risk-reward ratio here is the comparison of how much you can win to how much you can lose in a trade. As you grow as a trader, you will learn that the risk: reward ratio goes a long way in enabling you to estimate the win rate of your trading strategy even before you enter a trade. The ratio also gives you a better understanding of your performance in the market.
Now that you understand why it’s essential to use a stop loss, next we will explore tips for better stop loss placement.
Tips for Better Stop Loss Placement
Most traders don’t give the stop loss placement process as much attention as it deserves. In fact, some of them don’t even have a strategy for placing a stop loss. They just set the stop loss at any random level, and this the recipe for failure. Here are some credible tips for better stop loss placement.
· The correct process of placing stops
Although most traders start with good intentions, their execution fails them. They begin by estimating how big their position should be and then place a random stop loss.
A better process would be to first identify the stop loss level (a few pips below support or resistance level) then determine the position size and proceed to execute the trade if you are okay with it.
The rule of thumb is that never risk more than 1% of your trading balance on a single trade. Experienced traders may go slightly higher with a maximum risk of 2%.
· Use reasonable price levels
Most traders fail to understand what a stop loss is. A stop loss is the price level where your trade idea ceases to be valid. It’s normal for the crypto markets to pull back, but there is a point at which your trading idea loses its validity.
It is for this reason that you should ensure that the price levels for your stop-loss order are reasonable. Traders who depend on random stop-loss orders often find themselves re-entering the market to ‘revenge trade’ because their unreasonable expectations lead them to believe that their trade idea can still work.
· Stick to your stop loss and don’t take losses personally
It’s normal to lose in trading. It’s not possible to have a 100%-win rate. The mere fact that prices hit your stop loss is not a sign that you are a bad trader. Just understand that your trade didn’t work.
Unfortunately, during market reversals, some traders keep moving their stop loss in the hope that the market will soon trend in their favour. Don’t fall for this mistake. While the markets have a chance to gain, they also have the potential to wipe out your investment.
Practical Example on how to Trail Your Stop Loss in an Uptrend
A bullish market comprises of higher highs and lows. In such a market, you can leverage on the swing lows to trail your stop loss. This is simply because these are the support levels where the trend holds. Here is how to do it:
- First, identify the previous swing low.
- Next, place your stop loss below the swing low, and trail it at your desired distance.
- If the market moves below the swing low, you automatically exit the trade.
Common Mistakes about Stop-Loss Orders
· The hindsight fallacy
Always think long term when placing your stop-loss order. Don’t alter your approach on a trade-to-trade basis. Set your rules, follow them and then evaluate your data so you can come up with ways to improve your trading.
· Trying to be the break-even trader
Most armature traders place their stop-loss orders at their entry point to avoid making a loss. Even though you are trying to break even, this is a rookie mistake because experienced traders and brokers can already read your mind. This makes it easy for them to stop-hunt.
· Thinking that not using a stop gives you flexibility and avoids stop hunting
Don’t fall for the myth that failing to use a stop-loss order will provide you with the flexibility to react to sudden price moves in the market. The truth is that failure to use a stop loss puts you in danger of being wiped out in one trade.
What is more, you will find it challenging to use a practical position and money sizing strategy when you don’t have a stop-loss order.
Final Word on Adding a Stop Loss to Exchange Trades
As you can see, it is crucial to add a stop loss to your trading strategy. Here are a recap and some closing thoughts:
- A stop loss is a critical addition to your initial entry order
- You can use a hard stop loss or a trailing stop loss
- Stop-loss should be at invalidation level
- When the price hits the stop-loss order, your trade closes automatically
- The gap between the stop-loss order and your entry point represents your risk capital on a trade
- If you are not using a stop loss, you could be exposing your full account balance to a single trade
About the author:
Jay Jackson is a blockchain enthusiast and a freelance writer at topcryptowriter.com. He works closely with brands (people, businesses and startups) in the crypto sphere. He currently writes Blog posts, Guides, Press releases, ICO reviews, eBooks & Whitepapers. You can find him on LinkedIn.
The above references an opinion and is for informational purposes only. Do not take this as personalised financial or investment advice. The views expressed by the author do not necessarily represent the opinion of BitPrime.
Last updated: 09/10/2019