Risk mitigation is a huge part of an investment. It is defined as the steps taken to reduce unwanted effects. There are many kinds of approaches taken in business risk mitigation. In general, the approaches can either involve transference, acceptance, interference or avoidance. One of the most common risk avoidance tools used in business is the stop loss. This tool completely removes the business from exposure to common risks. Traders in all kinds of markets use this method to safeguard their assets when they are trading in unpredictable markets. In order to understand how to use the stop loss, we must first define it and learn what it is about.
What Is The Stop Loss?
The stop loss is a tool commonly by investors and traders to mitigate losses. The tool is used on orders that are likely to make losses. It is placed at a position where the trader does not want losses to go past. The exit point helps a trader to save their money in case the market goes awry. In practical terms, the stop loss is placed a few points lower than the value of the investment. The stop loss is automatically triggered once the predetermined condition has been met. Stop losses are very crucial in volatile markets where it is not easy to predict the movement of prices.
Stop losses are not only for preventing losses, however. The tools can be used to take a certain level of profit. This scenario is the opposite of the former case where the limits are placed below a certain point. When used to lock in profits, the tool is placed above the price point so that it exits the market immediately the desired point is crossed. Traders in forex markets used stop losses a lot. The tools can also be used in the securities market. The manner in which the tool is used is however dependent on the dynamics of the market (visit this webinar to learn more).
How To Reduce Trading Risk with Stop Losses
With the right techniques, it is possible to reduce losses with a stop loss strategy. In order for the strategy to work, however, you must understand how to:
- Set the correct stop loss positions
- Apply a stop loss for the right purpose
To start off, you need to establish the prices at which you can either buy or sell. The buy price is commonly referred to as the asking price while the sale price is known as the bid price. It is crucial to identify the bid and ask prices so that you can come up with the appropriate stop loss levels. In case your market prediction goes short, then the asking price triggers the stop loss. The opposite also happens in case you made a long market prediction.
As for the purpose of the stop loss, you should always keep in mind that it is for reducing the exposure to risk. The strategy is thus not only recommended for risky trades but all trades that might need the automatic execution of a market move in case the market goes in an unpredictable manner. The stop loss works on an individual basis and should thus be monitored in every case.
Possible Issues With Stop Losses
While stop losses are expected to prevent losses, they might not always be effective in doing so. In instances where the market closes high but opens the next day from a low position, stop losses that have been set at the previous market prices will not work. Sometimes, the assets in the market might take a huge fall because of catastrophic events in the market. At such times, huge disruptions take place and the market price of assets can fall much faster than expected. The prevailing stop loss points thus are left out of the market range.
Stop losses are excellent tools for reducing risk when trading but they do not come without a fair share of disadvantages. The successful deployment and use of a stop loss depend on other factors like how informed a trader is about the market. Using the stop loss effectively can thus go a long way in maximizing the investments of a trader but the strategy should also be used with caution.
Categories: Stock Market