Are you contemplating investing in either forex or the stock market? Well, consider having in place an effective way to control open trading positions. The best way is to set off stop-loss or take-profit prompts as an exit strategy. What do the two terms mean? Stop loss helps in defining the risk ratio, plus the amount one is comfortable losing on one trade. Take-profit is put in place to prevent the urge to re-invest all the profits. It locks the profits either on short- or long-term price actions.
Ordinarily, no one gets in trading to lose money but to potentially make some profit. There has to be some level of caution when checking all the trades being executed. However, many traders are always struggling with where and when doing so.
In this post, we will go into detail about why you should embrace the two trading tools for all your financial investments. We will talk about the below topics:
- What are Stop-loss and Take-profit orders?
- How Can Stop-loss Strategies help Minimise Risk?
- How to set Stop-loss Targets
- How do Take-profit Strategies Work?
What are Stop-Loss and Take-Profit Orders?
The stop-loss plan caps the maximum loss one can make in a trading position. Take-profit evaluates a certain value with which a trader is comfortable to close a trade position on an asset for a profit. The combination of the two, enables the trader to come up with a risk ratio format that would work for the long-term investment. This keeps the potential downside lower compared to the potential upside.
How the stop-loss order works
Stop-loss is put in place to safeguard investments. Once set, if the price of any asset drops below the trader’s stop price, the stop-loss order comes into play. Following the above scenario, a market order is executed, allowing the asset to sell on the next price available beneath the stop-loss level. For example, if you bought 20 shares in Afrique enterprises at 100 USD each, totaling 2000 USD investment, you can decide to set the stop-loss limit at 1950 USD. If Afrique’s share price tumbles days after your action and goes below the stop-loss limit, let’s say it closes at 1940 USD, it will still be executed, making an overall loss of $60.
How the take-profit order works
Take-profit is also referred to as “limit-order”. It guarantees that you close your trading position at or above the pre-defined price cap. Where an asset’s position moves towards the direction of the take-profit level, it is closed to gain profit. Take-profit order is the populist term in short-term trading. To monitor their hourly or daily price movement, traders use take-profit to execute any trade devoid of human involvement. Using the two, a trader can control the reward ratio versus the risk of all trades they enter. Continue reading to learn how stop-loss & take-profit work.
How Can Stop-Loss Strategies Help Minimise Risk?
To minimise risk, a trader needs to know more about the two orders. To manage their trading positions professionally, some strategies that are associated with stop-loss and take-profit are crucial. Once stop-loss is in place, micro-managing your investment becomes a thing of the past. Once the size of your stop-loss is specified, enter the order in the market and wait until it’s triggered. Stop-loss order has its drawbacks, such as when there are short-term market spikes that recover or become profitable on medium/long-term trading. The order can be best employed in the below scenarios:
- Assets undergoing bearish downtrends or a shares market correction because of technical analysis.
- Cryptocurrencies or stocks on a bullish uptrend without apparent near risk.
- Where markets are uncertain and the firms have strong fundamentals.
- Any trading opportunities that use fundamental analysis, i.e. news stories/press releases with high leverage.
Stop-loss techniques applied
For a trader to protect their profits, using a stop-loss could be useful. One can change the standard stop-loss and have a form known as trailing stop. Traders can then adjust the trailing stop on a pre-defined monetary value or percentage of the assets’ prevailing value in the market. For traders that will buy or go long on any stock, they will have to put the trailing stop below the asset’s market value. If a trader wants to sell (short) on a stock, they will need to place the trailing stop-loss beyond the value in the market. If the open position moves towards your intended direction, the trailing stop goes with you. It trails the prevailing market value, then closes your position if the market cuts some gains or losses on the stock.
Calculating the risk ratio while trading online
Once the trader understands how stop-loss and take-profit concepts work, it is very easy to estimate their reward or risk calculation as they do their online trading. It does not matter whether you are a newbie or an experienced trader, once you employ proper risk management, you can use the two and make your trade successful.
For example, working on the risk ratio, the trader needs to divide their targeted net profit with the maximum risk price (the placing of their stop-loss order). Few traders consider reward or risk ratios below 2:1 (where one risks 1USD to get 2 USD). However, this is the best way to ensure their bankrolling lasts. It also lets them ride out in both peaks and troughs as they trade.
A word of caution, though, bankrolling poor management strategies could lead to loss of money.
How to Set Stop-Loss Targets
Your risk threshold determines the placing of your stop-loss order. Remember, traders should take the action as the worst situation that would signal that the share price judgment in the market was wrong, therefore need to limit losses. After defining your minimum reward or risk ratio that is okay with you, placing your stop-loss order will be very simple.
Advantages of a stop-loss order
- The stop-loss order helps in automating the sale of assets or stocks, minimising human activity in your trading portfolio. The order is automatically activated once the asset’s price touches the set price.
- It protects a trader against big losses in the market. Even where the price goes down past the set price, the trader only experiences minimal losses, if any.
- Stop-loss promotes self-discipline in trading. It encourages adhering to financial strategies and methods, hence removing personal over-involvement.
- It helps in balancing the reward and risk as one trades in the stock market.
Disadvantages of a stop-loss order
- If you are using a broker, some brokers charge for the service, therefore, you will incur some additional costs.
- The trader has to decide the price to set as the stop-loss, which is challenging and tricky. To avoid this, you can seek help from financial experts; however, it will not be free.
- Any form of short-term price fluctuation can trigger the stop-loss order, hence disrupting the intended purpose.
- Sometimes, a trader is forced to sell their assets too soon or abruptly. It limits making more profits or cuts short a trend that would have turned to be a potential profit where a trader would have gone for high-risk level.
How do Take-profit Strategies Work?
Take-profit orders are popular among short-term traders. They are used to feed off both fluctuations and volatility in an asset’s value in financial investments. The most challenging part for many traders is knowing when to get their profits. Taking too long, might see the trader missing the best trade exit point, losing the gains earned. Take-off order ends the open position of gaining profit once the trade reaches a pre-determined monetary or profit value. One thing it does is to remove all human emotional attachments from executing a trade. The trader is no longer at ease, eager, or stressed regarding selling or holding on to an asset.
Where to apply the take-profit order
As previously said, each trade requires an exit strategy once certain profit anticipation is reached. To get in any trade is very easy. However, how and where you get out largely influences your profit or loss. There are set terms or conditions that determine where or when to place a take-profit order.
Here is an example: if a trader buys an asset at 10.50 USD, and puts a profit target of 10.65USD, then you place a take-profit order at 10.65 USD.
However, the profit margins or targets comprise merits and demerits.
Why is take-profit so important?
To know where to call it quits before the commencement of a trade enables a trader to calculate the reward/risk ratio. However, it is important to understand that it is impossible to know the investments or trades that will be successful or not. Placing several trading positions is likely to bring more or higher profits. To know whether a trade is worth the pain, a trader can use the profit target. Where the profit is less than the risk, think twice before taking the trade to avoid shockers. Therefore, we can authoritatively say profit target filters out unworthy trades.
How to set a take-profit order
A trader can use several strategies in setting up a take-profit order. Below are some tested and tried methods to apply:
- Using the moving average: one can place their take-profit order when the market periods are trending. Others do it based on or near the moving average price, especially if a stock dives beneath the mid of the moving average.
- Price action suggests a shift in the market sentiment: for example, using signals that entirely rely on price action to determine varying market sentiments. Using bars and rejections at either highs or lows is a good example of the above scenario.
- Using peaks and troughs: a trader can use Fibonacci extensions to get an idea of an asset’s return potential at the extension of its trend.
- The support and resistance levels: here a trader can use technical analysis to highlight resistance and support points then, use the past highs and lows in setting a take-profit order.
Advantages and disadvantages of a take-profit order
Take-profit or profit target has several benefits and drawbacks. Let us have a look at them.
- A trader can know the reward or risk of a trade even before placing a position. Equipped with this information, the trader can make an informed decision whether to take the trade.
- It helps in eliminating the human emotional part since the trader can see or base their judgment on tangible charts or data.
- It psychologically prepares the trader before the outcome. Whether the trader loses, it does not come as a shocker.
- Not every trader places a take-profit because some knowledge is required. A trader will, therefore, need to invest in learning resources and networking with experienced traders.
- Once a take-profit price is reached, a trader cannot get beyond that. If a trade sets a take-profit at $10.25, they lose any profit beyond the set target, i.e. anything beyond $10.25 is lost. However, a trader can take a new trade in case the price continues in a favorable direction.
- Finally, there is also a possibility of not reaching the desired goal, if a trader cannot reach the take-profit order. This happens when the price moves towards the set goal only to reverse hitting the stop-loss order. To sum up, farfetched profit targets will not win many trades. If the command is set so close, a trader might not be compensated for the risk they are taking.
One of the easiest methods of learning the market orders and applying them confidently is by following more experienced traders to have a glimpse of what they do, and how they do it. Some forex trading platforms have come up with user-friendly and accessible tools to make it easy for a beginner to trade without many hurdles. Online trading platforms also make it possible to copy other portfolios to automate and diversify their trading positions. After mastering the stop-loss and take-profit orders, a trader can use their broker accounts to invest more, fully aware of both the worst and best scenarios.
This information is not considered as investment advice or an investment recommendation, but instead a marketing communication. FXCess is not responsible for any data or information provided by third parties referenced, or hyperlinked, in this communication