What is a Stop Loss Order? and Factors to Consider When Setting

Stop Loss Order is a type of order that is set after opening a trade that is intended to cut losses if the 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 broker that will automatically close your stock trade transaction when it reaches a predetermined price. When set level is reached, your open trade is liquidated.

These orders are intended to restrict the sum of money that trader can lose: by exiting the transaction if a specific price that is against the trade is reached.

Regardless of what you might be told by others, there's no question about if these orders should or should not be set - these orders should always be set.

One of the most troublesome things in 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 prices, not higher.

The critics will also argue that in setting stops you are vulnerable to exit a transaction just before the market moves in your favor. Most investors have had the experience of setting a these orders and then seeing the price retrace to that level, or just below it, and then go in direction of their original market trend analysis. What might have been a profitable trade transaction now instead turns into a loss trade.

Experienced traders always use stop orders as they are a crucial part of the discipline required to succeed because they can limit a small loss from becoming a large one. What's more, by purposefully putting these orders whenever you enter a position, you end up making this important decision at the point in time when you're most objective about what's really happening with market, this is because the most unbiased analysis is done before opening a trade transaction. After opening the market an investor will tend to interpret the market differently because now they have a bias toward one-sidea-particular-side, the direction of their analysis.

Unexpected news can come out of nowhere and significantly affect the price: this is why it is so important to have a stop loss order. Its best to cap losses early when a trade position is moving against you, it is best to cap your losses immediately rather than waiting it to become a big one. Again, if you set your stop loss orders when you are entering a trade transaction, then that is when you are most unbiased.

A key question is exactly where to place this order. In other words, how far should you place this below your purchase price? Many traders will tell you to set predetermined - maximum acceptable loss, an amount that is based on your trading account balance rather than use of technical indicators of the stock indices instrument in question.

Experienced money managers instruct that you should not lose more than 2 percent of your account equity on any single stock indices transaction. If you have $50,000 in trading capital, then that would mean the maximum loss you should set for any single transaction is $1,000.

If you bought 1 standard lot of a stock indices instrument, then you would cap your trading risk to no more than $1,000. In which case you would put your stop loss order at 100 pips (points) and would have $49,000 left in your account if you closed the trade transaction at the maximum loss allowed. The topic of Stock Indices Trading risk management is wide & it is covered in the money management topics.

• Stock Index Money Management Introduction
• Indices Money Management Strategies

Factors to Consider When Setting

The most important question is how close or how far this order should be from the price where you entered the position. Where you set will depend on several factors:

Since there aren't any rules set in stone as to where you should place these levels on a chart, we follow general guidelines that are used to help put 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 price range of a stock indices. If a stock indices instrument regularly moves up and down in a range of 100 pips or more over the course of the day, then you can't set a tight stop loss order. If you do, you will be taken out of the trade position by the normal market volatility.

3. Risk to reward ratio - this is the measure of potential reward to risk. If the market conditions are favorable then it's possible to comfortably give your trade more space. However, if the 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 isn't in your favor and even placing tight stop loss orders will not guarantee profitable results. It would be more wiser to look for a much better trade transaction next time.

4. Position size - if the position size opened is too big then even the smallest decimal price movement will be fairly large in percentage terms. This means that you have to put a tight stop loss which might be taken out more easily. In many cases it's better to shift to a smaller trade transaction so-as-tosothat-to allow your trade position more space for fluctuating, by placing a fair level for this order while at the same time limiting the risk.

5. Account Capital - If your account is under-capitalized then you will not be able to set your stops accordingly, because you'll have a big amount of money in a single trade transaction which will obligate you to put very close stops. If this is the case, you should contemplate seriously about whether you have sufficient capital to trade Stock Indices in the first place.

6. Market conditions - If the price is trending upwards, a tight stop might not be necessary. If on the other hand the price is choppy and has no clear market trend direction then you should use a tight stop loss or not execute any transactions at all.

7. Chart Time-Frame - the bigger the chart time-frame you use, the bigger the stop should be. If you were a scalping your stops would be tighter than if you were a day or a swing trader. This is because if you're using longer chart timeframes and you figure out the price will be move up it does not make sense to set a very closetight stop loss order because if the 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 & support zones. These areas give good points for setting these trade stop orders as they are the most reliable zones, 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 strategy.