What is a Stop Loss Stock Index Order? and Factors to Consider When Setting
Stop Loss Stock Indices Order is a type of order placed after opening a trade that is meant to cut losses if the stock index market trend moves against you.
It is a predetermined point of exiting a losing transaction and it's meant to control losses.
A stop loss is an order placed with your stock indices broker that will automatically close your stock indices trade transaction when it reaches a predetermined stock index price. When set level is reached, your open trade is liquidated.
These stock indices orders are designed to limit the amount of money that trader can lose: by exiting the transaction if a specific stock index price that is against the trade is reached.
Regardless of what you might be told by others, there is no question about whether these orders should or should not be used - they should always be used.
One of the most difficult things in Stock Indices Trading is setting these orders. Put the stop loss too close to your entry price & you're liable to exit the trade due to random market volatility. Place it too far away and if you are on the wrong side of the trend, then a small loss could turn into a large one.
Skeptics will point out several disadvantages of these orders: that by placing them you are guaranteeing that, should your open position move in the wrong direction, you will end up selling at lower stock index prices, not higher.
The critics will also argue that in setting stops you are vulnerable to exit a transaction just before the stock indices market moves in your favor. Most investors have had the experience of setting a these orders and then seeing the stock index price retrace to that level, or just below it, and then go in direction of their original market stock indices trend analysis. What might have been a profitable position instead turns into a loss.
Experienced traders always use stops as they are an important part of the discipline required to succeed because they can prevent a small loss from becoming a large one. What's more, by diligently setting these orders whenever you enter a position, you end up making this important decision at the point in time when you are most objective about what's really happening with stock indices market, this is because the most objective technical analysis is done before opening a transaction. After entering the stock indices market an investor will tend to interpret the stock indices market differently because they have a bias towards one side, the direction of their analysis.
Unexpected news can come out of the blue and dramatically affect the stock index price: this is why it's so important to have a stop loss. Its best to cut losses early when a position is going against you, it is best to cut your losses immediately rather than waiting it to become a big one. Again, if you set your stops when you are entering a trade, then that is when you are most objective.
A key question is exactly where to place this order. In other words, how far should you place this below your purchase index price? Many traders will tell you to set predetermined - maximum acceptable loss, an amount based on your account balance rather than use technical indicators of the stock indices instrument in question.
Professional money managers advice that you should not lose more than 2% of your account equity on any one single stock indices transaction. If you have $50,000 in capital, then that would mean the maximum loss you should set for any one single transaction is $1,000.
If you bought 1 standard lot of a stock indices instrument, then you would limit your risk to no more than $1,000. In that case you would set your stop loss at 100 pips (points) and would have $49,000 left if you exited the position at the maximum loss allowed. The topic of Stock Indices Trading risk management is wide and it is covered under money management topics.
Factors to Consider When Setting
The most important question is how close or how far this order should be from the stock index price where you entered the position. Where you set will depend on several factors:
Since there are no rules set in stone as to where you should place these levels on a stock indices chart, we follow general guidelines used to help place these levels correctly.
Some of the general guidelines used are:
1. Risk - How much is one willing to lose on a single transaction. General rule is that a trader should never lose more than 2 percentage of the total account capital on any one single transaction.
2. Volatility - this refers to the daily stock index price range of a stock indices. If a stock indices instrument routinely moves up and down in a range of 100 pips or more over the course of the day, then you cannot set a tight stop loss. If you do, you'll be taken out of the position by the normal market volatility.
3. Risk to reward ratio - this is the measure of potential reward to risk. If the stock indices market conditions are favorable then it is possible to comfortably give your trade more room. However, if the stock indices market is too choppy it then becomes too risky to open a transaction without a tight stop then don't make the trade at all. The risk to reward is not in your favor and even setting tight stops will not guarantee profitable results. It would be wiser to look for a better position to next time.
4. Position size - if the position size opened is too big then even the smallest decimal stock index price movement will be fairly large in percentage terms. This means that you have to set a tight stop which may be taken out more easily. In most cases it's better to adjust to a smaller position size so as to give your trade more space for fluctuation, by setting a reasonable level for this order while at the same time reducing the risk.
5. Account Capital - If your account is under-capitalized then you will not be able to set your stops accordingly, because you will have a large amount of money in a single position which will force you to set very tight stops. If this is the case, you should think seriously about whether you have enough capital to trade Stock Indices in the first place.
6. Market conditions - If the stock index price is trending upward, a tight stop might not be necessary. If on the other hand the stock index price is choppy and has no clear direction then you should use a tight stop or not open any trades at all.
7. Chart Time frame - the bigger the chart time frame you use, the bigger the stop should be. If you were a scalper your stops would be tighter than if you were a day or a swing trader. This is because if you are using longer chart timeframes and you figure out the stock index price will be move up it does not make sense to set a very tight stop because if the stock index price swings a little your order will be hit.
The method of setting that you choose will significantly depend on what type of trader you are. Most commonly used technique to determine where to set is - resistance and support levels. These areas give good points for setting these trade orders as they are the most reliable, because the support & resistance levels won't be hit many times.
The method of how to set these stops that you select should also follow the guidelines above, even if not all those who apply to your stock index trading strategy.
