21 September 2022 • 6 min read
The importance of risk management cannot be overstated, especially in an environment as volatile as the crypto market. Quite simply, stop-loss is one of the most straightforward risk management measures that a trader can take. Not only does it limit your potential downside, but it also helps you avoid irrational trading.
In the following article, we’ll take a closer look at stop-losses and, in the process, learn all about why they are important and the many different types of stop-losses as well as how and why you should be using them whenever you’re trading crypto.
Let’s get started!
A stop-loss is an order that traders attach to their trades to exit a position if the market moves against them.
As the name suggests, they are designed to limit a trader's downside by closing out a position if the market trends in the opposite direction. For example, if you open a short position, you hope the price drops. Instead, if the currency pair rises, you are accruing losses on your trading account. If these losses continue, your account could be wiped out. Setting a stop-loss order lets you automatically close your position if the losses accrued in your trading account reach a specific level.
When setting your stop-loss and take-profit levels, consider the current market volatility and the duration you intend to hold your position. Technical indicators that measure market volatility, such as the average true range (ATR), will come in handy here. Note that you can also set your stop-loss arbitrarily depending on your risk profile. H
Curious about how they’re set? Read on!
The stop-loss level is set above the selling price when taking a short position. When you short the market, you expect that the prices will drop. If the market adopts an uptrend, it means that your trading account will accrue losses. Setting a stop-loss ensures the losses you take are capped.
The stop-loss is set below the entry price for a long trade. When you open a long position, you expect the price to rise. So, in this case, your downside is the price dropping. On the off-chance that the price drops, setting a stop-loss ensures that your trade will be closed at a specific level, preventing your account from further losses.
Stop-losses can be extremely important, whether you’re trading long or short. Let’s take a look at some of the advantages.
As we mentioned, stop-loss limits your downside. Setting the stop-loss ensures that, if the worst comes to pass, you will only lose what you can afford to lose, especially when trading with leverage as is the case with margin trading. It ensures that any one bad trade cannot significantly impact your account beyond the amount you've set.
For example, let's say you have a $1000 account and set your stop-loss at $50. When the market goes against you, you will only lose a maximum of $50. But if you didn't have a stop-loss, your account could be wiped out by a bad trade.
Both inexperienced and experienced traders are not immune to emotional impulses when trading, especially when they find themselves in a losing position. Setting a stop-loss insulates you from making emotional decisions that may negatively impact your trade. Without a stop-loss, you may panic and prematurely close your position. Conversely, you may also be prone to staying longer in a losing trade. The stop-loss ensures that you stick with your strategy.
For example, say you've done your analysis and bought Ethereum, but your position doesn't have a stop-loss. When ETH begins to drop, as it did following the Merge, you still have the conviction that your analysis is accurate and that it will begin to rise again. You'll be tempted to keep the position open even if ETH goes into a freefall, which could wipe out your account.
Once you've set your stop-loss after opening a trade, you don't need to continue monitoring the trade. When you combine it with take-profit targets, your trade will automatically close when the price reaches the SL or hits the profit target. This frees you up to pursue other interests and relieves you of the stress of continuously watching a fluctuating market.
This applies to trailing stops. Trailing stops are used to protect losses of accumulated profits. Trailing stop orders are often attached to some pips below the prevailing market price for a long position and above the market price for a short position. This means that when the price fluctuates, the trailing stop changes along with it. When the trend changes, your position will be closed when the market price reaches the trailing stop level.
There are four common types of stop-losses: trailing stop-loss, time-based stop-loss, equity stop-loss, and volatility stop-loss.
A trailing stop is a variation of the stop-loss, but it doesn't have a fixed stop price. Instead, the stop price is attached at some pips below or above the prevailing market price. As the asset price trends in a favorable direction, the trailing stop level adjusts itself (i.e., trails) the market price by the predetermined amount. However, if the asset price trends in an unfavorable direction, the trailing stop remains intact, and the position will be closed if the price reaches the trailing stop price.
Trailing stops are ideal for securing the profits you have earned up to a certain period. For example, if the market trends your way for some time, your trade is profitable, but, if the trend reverses before the price hits your take-profit level, you stand to lose all the profits accumulated up to that point. This is where the trailing stop comes into play.
The trailing stop is attached at some pips below the prevailing market price in a bullish position. This means that when the price rises in an open position and your profits accumulate, the trailing stop also rises along with it. When the trend changes and the market adopts a bearish trend, your position will be closed when the market price reaches the trailing stop.
The trailing stop is placed at specific points above the market price for a short position. As the downtrend continues, the trailing stop will continue moving downwards, ensuring your profits are secured if the market reverses into a bullish trend.
Volatility stop-loss depends on the prevailing market volatility, and the open position is closed if the asset price fluctuates at predetermined market volatility. Technical indicators, such as the ATR that show market volatility, are used here. Naturally, when the volatility is high, the stop-loss is higher to account for larger market swings. And when volatility is low, the stop-loss should be conservative.
A time-based stop is a stop-loss triggered after a predetermined amount of time has elapsed. This means an open position is closed after a specific period, regardless of the price fluctuation. Typically, you let your trade run for some time and then close it if there isn't sufficient market movement, allowing you to free up your capital and trade more favorable assets rather than remain tied in a "dead trade."
You can set the time-based stop-loss depending on your trading strategy in minutes, hours, weeks, etc. For example, day traders can set their positions to close at a specific time of the day since they do not hold positions open overnight.
Equity stop-loss is the most common type of stop-loss. They are also called percentage stops because the stop-loss level is based on the amount of capital you're comfortable losing. Your position will be closed when the loss reaches the predetermined amount. Naturally, this type of stop differs depending on one's risk profile.
The chart stop-loss uses chart patterns and technical indicators to determine the optimal stop-loss level. In this case, traders use support and resistance levels, previous highs and lows, trendlines, and moving averages, among others.
Despite their proven advantages as a risk management tool, stop-loss orders can put traders at a disadvantage. The biggest disadvantage is that extreme short-term volatility could trigger the stop-loss, especially if there's a small margin between the entry price and the SL.
Typically, a market as volatile as the crypto is prone to short outbursts of extreme volatility occasioned by bouts of momentary price retractions. In these instances, your stop-loss may be triggered before the price retraces without adopting a new trend. To avoid this, you should consider combining different stop-losses, such as volatility, equity, and trailing stop-losses.
As one tool in your risk management portfolio, stop-losses are absolutely essential. In fact, their importance cannot be overstated.
And yet they are one of the most underrated aspects of healthy trading habits. Stop-loss targets help ensure that your downside is finite and limited if the market goes against you. They also prevent you from panicking and exiting your positions prematurely by engaging in emotional trading.
If you’re serious about your crypto trading game, then you’ll add stop-losses to your arsenal of weapons, particularly during a crypto winter, if you haven’t already done so!