To become a successful price action trader, you will need to know when—and how—to cut your losses and capture your winnings. Far too often, traders will hold onto their winning positions, hoping prices will climb even higher, only to eventually lose out. At the same time, traders will also hold onto their losing positions for far too long, hoping that things will only turn around, only to see their losses cut even deeper.
In both these instances, it’s easy to see how the always present forces of trading psychology—namely, fear and greed—can cloud our judgment and affect our decision-making. When traders abandon their initial trading plan, their exposure to risk will inevitably increase. Sticking with the plan and knowing when to close a specific position will maximize our potential successes.
Stop-loss orders and take profit orders are two extremely useful tools for traders of all types to use. Whether you plan on opening and closing your position within the same day or have a longer-term approach to the market, issuing these orders can help make your trading strategy significantly more precise.
In this article, we will answer some of the most common questions that traders have about stop loss and take profit orders. We believe that, regardless of your favored trading strategy, technical indicator, or risk tolerance, these tools should be used whenever a new position is opened.
What is a Stop Loss Order?
A Stop Loss Order is a specific trading order that instructs your “broker” (which might be a computer program) to sell shares of a specific stock as soon as the stock reaches a specific price. To put it simply, these orders help “stop” your losses before the price drops any lower. For example, suppose you purchase a stock at $20 per share. You might then choose to issue a 10 percent stop-loss order (at $18 per share). Once the stock’s value drops below $18, you will automatically close your position and sell at the market price (which could be just under $18 depending on what the market is offering).
What is a Take Profit Order?
A take-profit order is the exact opposite of a stop-loss order. When you issue a take-profit order, you wait until the price rises to a certain level and then close your position in response. If the stock you purchased cost $20 and you choose to issue a take profit order at 10 percent, this means you’ll be closing your position as soon as the price rises to $22.
Benefits of Issuing Stop Loss & Take Profit Orders
The majority of professional traders issue stop loss and take profit orders with every position they open—for good reason. A stop-loss order is a traders’ best weapon for minimizing risk. Suppose you purchase a stock valued at $100. When this is the case, your theoretical exposure to risk is $100, even if the proposed stock is a blue-chip stock that’s unlikely to lose all of its value. With a stop-loss order, demanding a sell at $90, the trader significantly reduces her risk exposure; even in the worst possible outcome, the trader would still only lose $10 (assuming the stock is liquid).
Above: Trading Chart with Take Profit and Stop Loss Orders (TradingView)
Take profit orders can similarly be used to reduce risk. Greed is one of the primary risks introduced by trading psychology. Too often, traders will enjoy a price rally and hope that the price will rise even higher—only to have their initial gains reversed and have the price reverted back to where they started. This especially true with assets that tend to trade within distinguishable price channels, such as stable currency pairs (USD-EUR, etc.). Planning in advance when you hope to exit a given position can help eliminate the risks created by greed and still allow you to earn a profit.
Limitations Created by Issuing Orders
Of course, stop loss and take profit orders inevitably have limitations. Regardless of the safeguards you choose to use, speculative trading will always necessarily carry some degree of risk.
Furthermore, some traders believe that using these sorts of orders can cause them to be overly conservative with the positions they end up taking. For example, if you buy a stock that is priced at $100 and issue a take profit order at $110, this creates a situation in which you can earn a 10 percent return. However, this also means that your return will be limited to exactly 10 percent. If the price climbs to $120 or even higher, the trader will end up missing out on an opportunity to earn more money.
At the same time, if you bought at $100 and issue a stop-loss order at $90, once the stock drops to $90, the order will cause you to effectively “lock-in” your losses—this means that if the stock were to rebound and bounce up to $100, you’ll be missing out on easy returns.
Despite these issues, it is still strongly recommended to issue orders with every position. Ultimately, orders are just tools—their usefulness (or lack thereof) will depend on how you choose to utilize them.
Stop Loss & Take Profit Orders: Best Practices
With both stop loss and take profit orders, there are several best practices you’ll want to keep in mind.
- Be realistic with your expectations: in addition to limiting the amount of capital you are willing to risk with each position (accounting for leverage, when applicable), you also need to be realistic about how much you expect to earn. Your loss tolerance and earnings goals should be decided in tandem with one another.
- Use pivot points: identifying pivot points and understanding the principles of market geometry can help you decide where your orders should be placed.
- Give yourself some room to breathe: stocks, currencies, and all other speculative assets experience varying degrees of volatility. Placing stop orders too close to the current price will often cause you to continually accumulate tiny losses.
- Identify the current trend: identifying the current trend, identifying the strength of the trend, and identifying what drives value will make it easier to place your orders appropriately. Using technical indicators can help (though they should not be exclusively relied upon).
- Stick with your plan: both greed and risk can cause people to make spontaneous adjustments once prices start to move. Remember, you choose your initial orders for a reason—trust your original instincts.
If you’ve never used stop-loss orders or take profit orders before, it is a good idea to begin trading on paper until you are ready to enter the market. These orders cannot guarantee any degree of profit, but when utilized correctly, they can help you manage your exposure to risk and your potential for strong returns. Because of this, even keeping their limitations in mind, we recommend never trading without stop loss.