Stop Loss Levels: A Necessity

If you have traded for CFDs or shares for any time at all, you will have come across the idea of a stop loss order. A stop loss order is an order to your broker to sell (if you have a long position) when the price drops to a certain level. This means that even if you are not watching the security, your broker will automatically close out your position for you, and you won't be open to any further losses. If you are short a position, the same applies in reverse.

The stop loss order simply becomes a market order to sell when the price is reached. With a normal stop loss order, if the stock or index breaches your preset stop loss level then the order is executed at the next available price. This means that in fact moving markets the exit order may be executed at a price lower than your stop loss price in the case of a long CFD position, or more than the stop loss price in the case of a short CFD position. All you can expect is for the broker to get the best available price for you, which will usually be reasonably near to the one you wanted. Even if you were watching the market every minute, this is the best you could do if you sold when the stop loss level was reached.

This is the way it works with any type of trading, including traditional share trading. If you choose to trade CFDs a stop loss order becomes even more important due to the mechanics of leverage potentially escalating the loss on a losing trade. If you miss exiting the market when holding shares, you just lose more of the value. If you don't exit the market from a losing position in CFDs, you can lose more money than you have originally outlaid when entering the trade or have in your account. This is the negative side of leverage which you otherwise hope will help magnify profits significantly in relation to the small initial margin required to establish the trade.

So for instance, a CFD trader taking a long position of $20,000 with a margin requirement of 10% (10-times leverage) may only need to place a deposit margin of $2000. This implies that a move of 10% in the asset's price will result in a 100% return (or loss) on the initial margin outlay. Naturally, here it is the downside that creates problems, so normally when you open a position with CFDs, you will also enter a stop loss order in case the price goes against you. This ensures that your trade is exited automatically should the market move against your position. Obviously, you hope the stop loss order will not be needed, but it's inevitable that some of your trades will go against you. However, because of the leverage even a regular stop loss order can result in you losing a significant amount of money.

A common mistake amongst newbie traders is the tendency to focus exclusively on positive outcomes. People prefer to think about how they could spend their trading profits, while disregarding the fact that the market could move against their positions. More experienced traders will focus on the downside risk of each trade and make this this is within their predefined parameters.

It is important to acknowledge and accept the fact as early in your trading career as possible that losing trades are an inevitable reality of trading. As traders we always try to maximise the number of profitable trades while reducing the number of losing trades but the truth unfortunately is that there are too many variables that influence stock prices at any one time to be able to predict the the outcome of a trade with any reasonable certainty. As opposed to trying to focus on getting the market direction correct, it is advisable to instead focus on perfecting the things that you have control over. This, in a nutshell, means controlling your risk.

Stop Loss versus Guaranteed Stop Loss Orders

In addition to normal stop loss orders when you trade CFDs you are sometimes able to get what is called a 'guaranteed stop loss'. This sounds ideal, because it guarantees to sell your losing contract at the price you specify, regardless of whether the market ever traded at that level or just shot straight through. Guaranteed stop loss orders means that your position will still be closed at the chosen price which may not be the case with a simple stop loss.

As you can see, this is a type of insurance, and therefore there is a cost associated with it. The broker for his part still has to sell at the best price available and make up the difference, if there is any, so the charge to you and other traders covers the difference. You are charged for a guaranteed stop loss when you take out the position, which means less profit even if the CFD goes straight up and you never need the stop loss. Therefore some traders only use them if the market is very volatile or the price is subject to frequent gapping. Amongst others, this would include low-volume shares, mining stocks and commodities.

A Tragic Example of the Importance of Stop-Loss Exit Levels

The so-called luck of the Irish ran out for Sean Quinn, reputed to be Irelandís richest man who built up a position in Anglo Irish Bank using CFDs. Quinnís interest in Anglo was first reported in January 2007 when he was named as the mystery investor who had bought up 5% of the bank.

By 2008 the Quinn family had utilized contracts for differences build a position equivalent to about 25% of Anglo, but as the value of the bank plunged he was on the wrong end of the CFD deal. Quinnís gamble on the share price going up backfired within months. On June 7, 2007, Angloís shares peaked at Ä17.53. Three months later, the share price started falling and it never recovered as the international banking sector collapsed, led by Bear Sterns in the United States and followed up Lehman Brothers. In July 2008 Quinn was forced to crystallise his losses by converting the CFDs into an ordinary 15% shareholding - a move which is reputed to have cost him circa 2.5bn euros (£2.2bn).