Trading on a stock exchange is always connected with great risks. That’s where Stop Loss and Take Profit come into play: these are helpful tools used by traders to minimize potential losses and maximize profits. Today, we’re going to find out how they work.
Stop Loss and Take Profit are protective orders set to automatically close a trade in order to limit losses and protect profits, respectively. In other words, these are signals to the broker to sell or buy your assets when their price reaches a certain level.
- Take Profit is an order to close the position when the asset price reaches a certain value in order to fix your profit.
- Stop Loss is an order to close the position when the asset price falls below a certain value in order to avoid serious losses.
With a long position, Take Profit is set above the current price, and Stop Loss is set below it.
Here’s an example. A trader buys Apple shares at $112 each and wants to sell them at $115. In this case, they set Take Profit at $115. Also, the trader doesn’t want to lose more than $2 to market fluctuations, and accordingly sets a Stop Loss of $110.
With a short position, Take Profit is set below the current price, and Stop Loss is set above it.
Let’s go back to the trader with the Apple stock. He goes short on Apple at $150 per share and wants to buy them back when the price drops to $120. In this case, Take Profit should be set at $120 and Stop Loss at $200 to avoid any serious losses.
The main purpose of setting these restrictions is to control the trading process when the trader is away from the terminal and doesn’t have an opportunity to continuously monitor the price fluctuations, or opens long-term orders. The market is volatile and does not forgive mistakes. Even the most seemingly lucrative trade can result in a major loss in a matter of minutes if the trader neglected the precautions.
All experienced traders understand the importance of Stop Loss and Take Profit as safety tools and actively use them. But novice traders often neglect these rules, which is why they doom themselves to constant losses.
Stop Loss and Take Profit set useful limits when trading in a volatile market, as well as in case of news trading. They are not limited in time and are valid until the trader cancels them. You can even set several Stop Losses or Take Profits for each asset. The advantage of a pre-set Stop Loss or Take Profit is in the ability to close an order automatically, which means it doesn’t require the constant attention of the trader behind the computer or on the phone. Long-term trading without limit orders is very dangerous even for an experienced trader.
The use of the Stop Loss is considered to be especially important, because large losses are significantly worse for the trader than ending up without the profit. Moreover, Stop Loss can replace Take Profit if the trader adjusts it up according to the price. A trade can be closed by Stop Loss, but the fixed profit will remain in the account. At the same time, ignoring the Stop Loss can lead to severe losses, resulting in a margin call (a broker’s requirement to deposit additional funds into the account lest the position be closed) and even zero balance and closed account.
How to calculate the value of Stop Loss and Take Profit?
First, you need to determine the Stop Loss. After that, you can calculate the Take Profit in order to maintain the correct ratio of potential profit and loss. Usually, it’s at least 1 to 2 (the more, the better). Establishing a profit cap is also important. Experienced traders warn not to overestimate the level of profit taking, since the price of an asset simply may not reach it in a volatile market. Important news releases, for example, can strongly affect the price of an instrument, including major currency pairs involving the US dollar.
Be sure to take into account the volatility of a particular trading instrument, which may differ depending on the day or time. In case of intraday trading, you can also check the readings of oscillators—indicators that help predict possible changes in the price direction. In addition, significant levels of support and resistance (narrow price corridors formed between several local highs and lows) and psychologically significant round levels can act as profit taking levels, while local highs and lows, as well as Fibonacci retracement levels can be used to finalize the transaction.
Knowledge of Stop Loss and Take Profit is beneficial to all participants in Forex trading. They are actively used by both professional traders and RAMM investors.
With the proper use of these tools, the foreign exchange market can become a good source of passive income that doesn’t require a permanent presence in the trading terminal.