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The Importance of Stop Losses

Importance of Utilising Stops
Written by Andy

Before trading contracts for difference you need to understand that CFDs are a margin-traded product and and that this can work for you as well as against you. Like all other leveraged financial products a small price movement can result in impressive returns but so can losses. The onus is really on the trader to appreciate the risks and to adopt a disciplined approach to control them. There are several ways to do this in practice, the most obvious being to de-gear the positions by depositing more margin. The key however is always to use stop losses. If these are set at appropriate levels then any potential losses should be sustainable. Despite these measures CFDs remain high-risk and nobody should trade them unless they fully understand the nature of the transaction and what is at stake.

Types of Order

Trading with real money should be viewed as a serious business. As such, you should take the time to ensure that you thoroughly understand the most basic tools of the business.

CFD providers now routinely support a range of sophisticated orders that are designed to help clients manage their positions and reduce the risks associated with adverse price movements. Perhaps the best known of these are stop orders which are an automated instruction to exit a position and realise a loss. In practice, orders can either be used to enter the market at a lower price than is currently available – a stop entry – or to limit the loss on an open position, the so-called stop loss.

A trader with a long CFD position would set a stop loss sell order below the current market price to automatically trigger a sell instruction should the price fall to that level. Most traders agree that the risks make it essential to use a stop loss, but that still leaves the issue of where best to set it. A good stop should not be too tight so as to close out a position prematurely or too wide so as to expose the trade to excessive risk.

A normal stop-loss order is only triggered if the market price matches the specified level of the stop, with the trade then automatically going through at the best price prevailing in the market. In effect the stop-loss sell turns into a market order as soon as the exchange price hits the stop level. These orders are free and will generally suffice. However the risk is that in a volatile market the price could gap well past the stop resulting in a bigger than anticipated loss. Because of this, the majority of providers now offer the alternative of a guaranteed stop or ‘limited risk transaction’. These instructions have to be placed when the position is first initiated and, as the name implies, have the effect of ensuring that the order is executed at the requested price – even where the market gaps past it such as in the case of a very sharp overnight move.

For instance if the futures market opens with a gap against your position, a normal stop-loss order will most likely not be filled at the price you specified. The term used in the industry is ‘slippage’ and it can hurt if overnight markets become volatile. A guaranteed stop on the other hand will be filled at the price you specify, even if the underlying market never trades that price. In effect it is like an insurance policy against a catastrophic event and for that reason CFD brokers charge a fee for using it, but it is money well spent for anyone concerned about market and account risk.

Other than managing risk using the different order types and hedging strategies CFD traders must also ensure that they adopt a strict money management regime, meaning that they should not use excessive leverage or overexpose themselves to one particular CFD position or industry sector. Abusing leverage is the single most common mistake made by newbie CFD traders.

Stop-Entry Order

Using a Stop entry order at first glance may seem a strange way of entering a particular market. The order works by specifying a minimum price you wish to pay for a long position and a maximum you wish to sell for a short position. Essentially in a fast or gapping market you have a risk of opening a position at a price quite different and disadvantaged to your stop entry level. The main reason for placing this particular type of order is to take advantage of a price breakout, typically if trading is stuck in a tight range then profits can be few and far between. Placing a stop-entry order at the top or bottom of the range means that if it breaks out and fills your order then the price may have left its tight range or support/resistance levels and it’s time for the price to reach new levels.

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