Stop Loss Orders

Have you heard of a stop loss order? When you buy or sell shares conventionally through a broker, you can place such an order which serves to limit your downside risk. Stop orders are useful when investing in shares, but are even more important when trading margined traded products as the risks are greater. Spread betting stops are the only way to cap potential losses.

An example of a normal risk-limited transaction would be:

‘Buy 1000 Marks & Spencer at 290, stop 220.’

A broker would interpret this order as follows: ‘Buy 1000 shares of Marks & Spencer at a price not exceeding £2.90 per share. If at any time the price falls below £2.20, then sell immediately at the best price without waiting for my intructions.’ Looked at another way, you are saying: ‘Buy £29,000 worth of Marks & Spencer shares, but bail me out if my losses exceed £7,000 – I don’t want to risk more than that’. It is possible to operate such risk-limiting orders through your spread betting company.

Whichever way you look at it although there is always a risk of getting stopped out prematurely, and missing on a potential quick price rebound, stop losses are in reality a crucial tool in risk management, particularly when margin borrowing is utilised.

Controlling the Risk with Stop Loss Orders

In order to make a long-term success of spread betting it is very important to make risk management a central aspect of your trading strategy from the outset. All successful spread traders keep a healthy relationship with risk. When you acquire trading experience your risk management strategy will continue to develop but for now let’s start with the basics; stops and limits.

Perhaps the most valuable form of order that you can use, the stop loss order does exactly what it says. It stops you losing any more money when you have a losing trade. You place the order at a certain price, and if the quoted price drops to this level your trade is closed out automatically. Your trade has been “Stopped out”. It locks in your loss, but stops you losing more if the price continues to go against you. You’re not given a warning, and you do not have to be watching the market.

Spread Betting Tip: Stop Losses

1. Before you even enter a trade you really must have decided when you will cut your losses and get out if it goes against you.
2. Be prepared for whatever the market throws at you.
3. Beware of placing very large stops – say stops of 400 or 500 points on say the FTSE 100 or Dow. Stops of this magnitude will require a lot of capital to sustain.

The stop loss is based on the charts it can often be set quite tight at just below key support levels. As far as risk management goes, most experienced traders adopt a strategy of risking a set amount of their trading capital per trade (say 5%). The way to do this is to identify where to put the stop loss level based on the chart and then adjust the stake size to get the suitable stake size. This kind of risk management helps to preserve your capital while enabling your to take advantage of market opportunities.

Stop Loss Example

Let’s assume you have just opened a trade long, you set a stop below your entry point in case the price goes against your position and you want the trade to be closed for a loss (known as being ‘Stopped out’).

NOTE: With some spread betting companies, using stop losses is compulsory.

In the example above (Figure 6) you went long on JJB Sports at 460. You also decide that if the price goes below 443 you wish to close the trade and cut your losses. So you place a stop order at 443. It is a stop order because the price has got worse for your position – you have made a loss. This is the normal use for a stop order hence it is often referred to as a stop loss.

One point to realize is that the price you set is not necessarily what the bet will be closed at. If the market is fluctuating wildly, this may mean that you lose more than you expected. What the stop loss order is saying to your spread betting broker is that if the price hits the set level, go ahead and close the position at whatever price the market will accept. Once a stock (or other market for that matter) hits the stop loss level, the spread betting provider will do their utmost to sell at the best price although there is a risk that they cannot close the trade at your specified level, in which case you might get a worse price. This could be the case if unexpected news hits the stock, like a profit warning, and the shares drop sharply when the market opens so you should always be wary of trading around company financial updates.

You always want to position your stop loss level with respect to how volatile the price is. If you set it too close to the price you open the trade at, then the price may fluctuate and trigger the order, even though it reverses straightaway and goes in the direction you had hoped. But of course, if you set it too far away you stand to lose more money on a losing trade. It is a good idea to look at the price chart and see how much it typically moves.

Another problem that can arise is when you have a limited amount on deposit with the broker, in comparison to your spread bet size. The broker may try to reduce the potential loss by limiting how far away from the initial price the stop loss order can be placed, in order to protect his position. This may cause the order to stop you out of a winning trade on a minor fluctuation. The answer in this case is to reduce the size of your bet, so that your account can handle a wider stoploss level.

If you have a winning trade, you can also use a stop loss order which you place after you are showing a profit, rather than at the same time as your initial bet. You simply place a stop loss order with the price higher than the opening price (for a long trade). If the price reverses, the bet will be stopped out at a higher level than the entry, locking in your profit. Again, do not place a stop loss order too close to the current price in case you’re stopped out on the fluctuations.