Stop-Loss Orders Explained

By mosesbet · Filed Under Spread Betting Comments Off on Stop-Loss Orders Explained 

Stop Loss Orders Explained

Spread betting carries a great deal of risk however one of the simplest ways for you to minimise your risks in trading is to implement a stop-loss order.  Beginners in particularly should always be using automatic stop-losses to minimise risks.  Because spread betting involves trading on leverage and margins you can end up losing far more than you deposited online.

A stop-loss order is ensures that you don’t lose more than you can afford.  It does this by automatically closing your trade if the price drops to a certain level. By cancelling your trade at a minimum price it prevents any more losses from your account.  Although the downside to stop-losses is that you’ll have to go forfeit some losses and the market could bounce back up again, the main advantage is that it protects you from massive drops in the market.

For example, let’s say you have £100 balance and place an order of £3 on the FTSE 100 at 400p.  Whilst placing your order you also set a stop-loss of 30 points.  This means that if the price of the FTSE 100 drops to 370p than you’re order will be exited at that price.  If the market drops 100 points down to 300p than without a stop-loss order you would have incurred a loss of £300.  However because you instructed your trade to automatically close at 370p you only suffered a maximum loss of £90.  You can easily cover the -£90 loss with the £100 funds in your account.

Are Stop-Losses Guaranteed?

Stop losses are never guaranteed to be executed because there’s no guaranteed that the market will drop to a certain price.  This means your order will stay open indefinitely until this happens.

The good news is that virtually all spread betting platforms will have automatic stop-losses to help minimise the risks of trading.  The actual stop-loss number varies between markets and brokers.  You’ll need to check the broker’s stop-loss guidelines on the website before you sign up or buy. For example, volatile markets such as the FTSE 250 might have an automatic stop loss of 100 whilst stable markets such as gold might only have a stop-loss of 20 points.

How is the Stop Loss Order Calculated?

Automatic stop loss orders are calculated by whichever is trigged first: if you reach 80% of your margin requirement (IMR) or if the price drops to 80% of the maximum margin requirement (usually 150 points).

For example, you have exactly £150 in your account and open a bet at £5 per point at 215p.  The minimum margin for the FTSE is 30 which means you need at least £150 in your account to keep your trade open (30×5).  A stop-loss will cancel your order automatically if you reach 80% of your total margin – which in this case would be if the FTSE dropped 24 points.

On another day let’s say you performed the same trade but you had £1,000 in your account.  This is more than enough to cover a 30 point drop; in fact you could cover a 200 point drop in total!  Instead, the broker calculates the maximum amount of margin which is required (150 points) and place the stop-loss 80% of this, which is 120 points.  Thus, if the FTSE 250 price drops 120 points than your automatic stop loss will cancel the trade.

Using Stop Losses as part of your Strategy

Stop losses should always be used when you open a trade to ensure a maximum level of risk for each order.  You should never place a stop-loss at more than you can afford to lose.

However, the level at which you place the stop-loss needs to be carefully planned.  For example, on a more volatile stock (where daily prices regularly bounce up and down) you’ll want to set your stop-loss at a slightly greater distance in order to stop your order from closing prematurely.

If you buy at 120p with a stop-loss at 90p and the market moves up to 140p than you might want to narrow the distance of your stop loss.  If you move your stop loss from 90p up to 120p than you can guarantee you won’t lose any money.

Risks of the Markets Gapping

“Gapping” is a market phenomenon when the position closes at less than your stop-loss because you leave your trade open overnight.

For example, if you leave a trade overnight for £1 at 140p and you have a stop loss at 120p, but the market falls to 100p overnight.   When the markets open the next morning you’re trade will cancel but you’ll still be liable for the difference between the position when you stopped and the position you opened the trade.

So, rather than automatically cancel your trade at 120p, it will actually only cancel at 100p, meaning you lose £20 as opposed to breaking-even.

 

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