The Importance of Using Stop Loss Orders When Spread Trading the Financial Markets

A Guide to Using Stop Loss Orders

Stop losses are market orders designed to allow you to limit your losses.

When you place a stop loss you are instructing the spread betting company or stock broker to cut your position when it reaches a certain loss level (or in some cases, profit level - more later).

Therefore, a stop loss will automatically close your trade if the market reaches a certain point.

For example: You have bought £1 a point of the German DAX at 4200. The most you are willing to risk is £150 on this trade so you place your stop at 4050. If the market trades at 4050 you are taken out immediately and you lose £150.

Normal Stop Losses

These are free but with this type of stop you can sometimes lose more than you specified when you placed the order.

Sometimes your stop loss order may not be filled at the level you wanted i.e. you may be taken out at 4046 instead of 4050.

The bookmaker will attempt to get you out of the trade at the price you specify but when the market is moving very quickly it may not be possible.

This is called "slippage" and tends to happen in a fast moving market.

You can also lose more than you wished if the market you are trading "gaps".

For example: You have opened a long trade on the Dow Jones for £1 a point at 10000. As you were willing to risk £200, you placed a stop at 9800. Over the next couple of days, the Dow moves down slightly to 9900 and at the end of trading on the third day it is sat at 9890.

The next day some very disappointing economic figures are released and the Dow opens well down at 9700. As this is past your stop loss, the bookmaker closes your bet at market price.

Your trade is closed at 9690, 110 points below your stop loss so your loss is now £310 rather than the £200 you were willing to lose.

Guaranteed Stop Losses

You can ensure you are closed out at the exact price you specify by using a Controlled Risk or Guaranteed stop loss order

These types of stops are designed as a type of insurance to guarantee that your stop loss order is filled at the exact price you specify.

Even if the market you are trading gaps 1000 points beyond your stop, if you are using a guaranteed stop loss you will still only lose what you have already decided is an acceptable loss.

You pay a little extra for a guaranteed stop. In the Dow example above, a guaranteed stop would cost roughly 4 times the stake (4 x £1 = £4). Usually the premium is taken from your account balance when setting the stop loss level or is added to the spread.

Although they do reduce your account balance, guaranteed stops can save you a great deal of money and are certainly recommended if you have a small capital base.

Some Pointers About Stop Losses

- Never move your stop if you think it may be hit. If you move the stop further down to try and avoid being taken out you will simply lose more money.

- You don't have to close your entire position with a stop loss order. If you wish, you can set up 2 or more stops. For a £1 per point trade you could set a stop 100 points away which reduces you exposure by 50p a point. Another could be placed 200 points away to take you completely out of the trade.

- It is better to let the stop take you out of the market and preserve the rest of your capital than to try and stay in the trade by moving the stop.

- You can lock in profits by using a stop loss. If you were to enter a long trade on the Dow at 10000 with a stop at 9900 and the Dow moves up to 10200 you could then move your stop to 10100 to lock in 100 points profit.

- Never trade without a stop loss, even if it is just a normal stop. To stay in the trading game you must preserve your capital and huge unexpected losses will certainly not help. See the Money Management section for more details.

Ben Catt is an active financial trader and runs a free website containing hints, tips and information about tax-free financial spread trading and betting in the UK. The site can be found at http://www.FinancialSpreadTrading.co.uk. He also runs a business opportunity information site - http://www.BizOppsUK.com