What is the meaning of a stop loss, and what role do stop loss orders play in your prop trading platforms? Learn more about the definition, concepts and benefits in this article.
Stop Loss Meaning
A stop loss is a price level, at which a trader intents to close a position in case that the original intent of the trade does not unfold. For example, if a trader opens a long position in futures contracts, he then aims to make a profit with rising prices of the underlying asset.
In case the prices fall, he faces a loss. A stop loss is the price level at which the trader then sells his futures contracts to realize the loss.
A stop loss can be set mentally. In that case the trader closes the position manually, once the price hits the defined stop loss price level.
Alternatively, he uses a stop loss order within his trading platform. In case the price hits that level, the position gets closes at the then best possible price.
Benefits of Using a Stop Loss
Limiting Risk
One of the core purposes of a stop-loss order is to cap the maximum potential loss on a trade. By setting a stop price level, the trader defines the worst-case scenario in terms of dollar losses. This prevents a small loss from turning into a catastrophic one if the trade continues moving against them. Capping losses preserves capital and allows traders to deploy funds into new opportunities.
Emotional Stress Reduction
Removing the emotional element of deciding when to exit a losing position:
Stop-loss orders help traders avoid the emotional biases that can cloud judgment when a position is losing money. It’s easy to become attached to a losing trade and hesitate to cut losses, a phenomenon known as the disposition effect. With a predetermined stop-loss level, the trade is exited automatically at that price, eliminating the need for an emotional decision in the heat of the moment. This objectivity helps traders stick to their strategy and avoid larger losses.
Increase Profit Potential
With a stop-loss order in place, traders don’t have to obsessively watch price movements. The order will automatically be executed if the stop price is hit, taking traders out of the position. This frees up time and mental energy to focus on other aspects of trading and investment strategy, rather than worrying about an open position 24/7. Traders can set the orders and allow trades to play out normally.
Capital Preservation
Capital preservation is crucial for sustainable long-term trading success. Even the best traders experience a series of losses. By using stop-loss orders to cap losses on losing trades, traders ensure they will have capital left over to take advantage of future opportunities that may arise. Blowing up an account due to unchecked losses makes it very difficult to continue trading and deploying capital effectively. Stop-losses help protect traders’ capital base.
