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What is Stop Loss (SL) and Take Profit (TP) and how to Use It?
Technology
Demetris Makrides
August 9, 2024
Introduction
Effective risk management is one of the most important skills for any trader to master. While making profitable trades is the goal, preservation of capital should always be the priority. A key way this is attained is by the strategic use of Stop Loss and Take Profit orders. SL and TP orders enable traders to get out of the market with discipline and objectivity, away from being influenced by the emotions of the two extremes.
The detailed guide below will enable you to understand stop loss and take profit in-depth, hence how to utilize them in your trading strategy. We will start by defining SL and TP and expound on core functions and benefits. Later in the text, we dive into the tech analysis concepts and different calculations that can help to come up with perfect SL and TP levels.
Next, we will cover how to implement SL and TP within a solid trading plan and how to avoid common mistakes. We will also touch on some advanced strategies, including trailing stops and multiple time frame analysis. By the end, you should feel confident in your ability to properly manage risk through a systematic approach to exiting all of your trades.
What is Stop Loss (SL) and Take Profit (TP)?
A stop loss can ideally be defined as a pre-set price below the price at which entering a trade takes place. When the market hits this price, it automatically sells to exit that position. A take profit is ideally set above the entry price and is supposed to be the peak favourable movement expected from the trade. Once it is triggered, a take profit may execute a buy order for the closing of a short position or a sell order to close a long position to bank the profits.
The difference between these orders—the stop-loss and take-profit—leads to different optimal applications for traders. Given that stop losses are, strictly speaking, market orders, they offer a better fit for short-term daily or intraday trades that ensure exiting. The design of trailing stops—where the price barrier dynamically changes with the trades—is more in line with medium- to long-term swing positions. These differences, though nuanced, are held at the forefront of how a cohesive overall strategy is structured.
Even within stop losses, some technical order types create trade-offs. A stop market order will execute instantly at the market price, taking on the slippage risks. A stop limit adds a buffer against adverse movements but might simply not trigger if there isn’t enough liquidity. Trailing stop orders try to balance these two: they let one optimally ride the trends by resetting the stop threshold, periodically, as the price fluctuates favourably.
The main goal for placing SL and TP orders is risk management. They eliminate disastrous small losses that otherwise could turn into big losses by taking the human emotions of fear and greed out of the exit decision. This will enable an individual to purely focus on the technical and basic analyses behind the initial trade. In addition to this, TP locks in profits at targeted resistance levels instead of being too greedy. SL orders are more critical, as you have determined to limit the losses, while the profits are still at your discretion.
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Differences between SL and TP
Purpose
- SL aims at restricting the loss and closing an adverse market.
- TP aims at securing the profits and closing a favourable trade.
Order Type
- Generally, SL employs the market type of orders, which are executed almost instantly; the disadvantage could be slippage in the execution.
- TP is a limit order to make sure a target price is received but does not fill in all scenarios.
Time Horizon
- SL is helpful for day trades or short-term swing trades that must ensure an exit from the position.
- TP can be applicably used in position trades where one’s positions are held for multiple timeframes.
Trailing Usage
- Trailing stop losses dynamically adjust the price barrier as favourable price action occurs.
- Trailing profits may not be as common since gains are to be secured at predetermined levels.
Risk Profile
- SL helps prevent small losses from transforming into drastic drawdowns if a trade reverses.
- TP allows one to take some profits but still holds on to some upside in case the price ventures into more significant gains.
Psychology
- A SL ensures discipline and removes the emotion of cutting damaging positions.
- TP targets lock in at least some gains to feel successful rather than greedy for maximum profit.
In summary: whereas both are risk management tools, SL focuses on downside protection by guaranteeing exits on deterioration; on the other hand, TP aims to secure upheld gains at optimal levels according to the original analysis and plan. Their roles are interlinked but distinct in their purposes.
Benefits of Using Stop Loss and Take Profit Orders
- Risk Management: SL/TP helps to prevent large potential deficiencies while keeping gains within predefined risk limits and holding the capital over time.
- Discipline: Having predefined points of exit largely reduces the effect that emotions like panic and greed have on any decisions that can be taken. It underscores the message of systematic trading by following a plan.
- Flexibility: Advanced order types, like Trailing Stops, make it easily adaptable for dynamic adjustments to exits in case the markets go favourably in your trade, making the most of your profits.
- Less Stress: Automatically exit positions through SL/TP levels rather than constantly watching them. It allows focusing on other opportunities.
- Better Performance: Following a strict regime of SL/TP over several trades ensures positive expectancy since it cuts losses short and allows winners to run.
Drawbacks of Stop Loss and Take Profit Orders
- Slippage: Drastic fluctuations in the volume markets might lead to the SL or TP prices being triggered through big spreads/slippage, not at a specific level.
- Early Exits: SP movements might close positions early and not catch bigger swings. This is particularly true for wider stops that are trying to contain minor fluctuations.
- Liquidity Risk: Thin order books mean that SL limit orders risk not filling at all if prices gap through the level without sufficient volume.
- Opportunity Cost: Taking profits through TPs can preclude closing out winning trades at all, which then keeps one out of the market to realize larger subsequent gains.
- System Failure: Meanwhile, for automated SL/TP, there will be the risk of software issues potentially hindering order placement and execution in very volatile and high-volume times.
Overall, used prudently after keeping in mind these possible limitations, SL and TP provide discernible benefits that outweigh the costs for disciplined traders respectful of the risk. Thorough testing of the strategies is extremely important.
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How To Calculate Stop Loss and Take Profit Levels
With the basics understood, the next important question is how to determine optimal levels for stop loss and take profit placement. There are a few approaches, often used together for robust confirmation:
Support and Resistance
Looking for areas on the price chart with the highest trading volumes offers insight into zones that have acted as barriers in the past. Traders typically place protective stops below recent support zones breached on larger time frames like the daily or weekly. Take profits are then set at the next resistant target.
Moving Averages
Simple or exponential moving averages (SMA/EMA) are trend-following indicators that smooth out price action. Breaks and retests of a longer term SMA like the 50-period can provide guideposts for SLs, while shorter MA crossovers help with TPs.
Fibonacci Retracements
By drawing Fibonacci retracement levels between the extremes of a significant move on the chart, these define potential pullback areas in percentages (38.2%, 50%, 61.8%). SLs are placed below key Fib levels on larger retracements to maintain position.
Percentage Based
This simplistic approach fixes SL at a set percentage below entry, like 3-5%, to control risk. Conversely, TP levels are targeted 2-3x the risk amount to achieve an acceptable risk:reward.
A trader must weigh each method, always incorporating the overall market context and their personal risk tolerance. The goal is to establish a logical, consistent system for calculating dynamic SL and TP levels on each trade. This makes for a far more rewarding trading experience in the long run.
Importance of Risk-Reward Ratio
Calculating a trade’s risk-reward ratio is an important part of determining appropriate stop loss and take profit levels. The ratio compares the potential reward from a trade to the amount of risk undertaken. Traders aim to structure positions where the expected profit significantly outweighs any maximum possible loss.
A risk-reward ratio of 1:2 or 1:3 means the first take profit target is double or triple the distance from the entry price to the stop loss level. Understanding this ratio helps identify trades presenting an asymmetrical payoff should the original analysis prove accurate.
The risk-reward ratio is calculated using a simple formula that divides the potential reward by the potential risk. For example, with an entry at $100, a stop loss at $95, and a first target at $105, the risk is $5 (Entry – Stop Loss) and the reward is $10 (Take Profit – Entry).
Plugging these numbers in gives a risk-reward ratio of 2:1. Targeting positions with favourable ratios emphasizes preserving capital while maintaining upside potential. Consistently focusing on trades with larger anticipated rewards compared to defined risks can produce a highly positive expectancy over numerous rounds.
Selecting entry points and accompanying stop loss and take profit levels directly impacts a trade’s risk-reward profile. Thorough back-testing can provide valuable statistics on which price levels tend to balance long-term viability with probabilistic outcomes.
Overall, comprehending risk-reward allows structuring activities for advantage probabilities that compound over the long run through reinvestment of profits and retention of capital. This steady optimization of processes eventually compounds wealth successfully over extended periods.
How To Use SL/TP in Your Trading Plan
Now that we’ve explored various considerations behind level placement, it’s crucial to outline exactly how these orders will fit into one’s overall trading strategy and plan. This clarity minimizes emotional decision-making and guides exit based purely on the initial technical or fundamental factors triggering the trade. Some important factors:
- Define Time Horizons: Will this be a short-term scalp or swing trade held for weeks? Set SL/TP expectations accordingly on smaller versus larger timeframes.
- Note Confirmation Rules: How many indications like moving average crossovers are required before entering? Add guidelines on when to tighten stops or take partial profits.
- Avoid Anchoring Bias: Don’t stubbornly cling to initial levels if markets move considerably against the position. Be ready to adjust promptly vs. bigger losses.
- Address Management: Will orders be trailed manually or using automatic features? Know the rules for partial closes or adding to winners.
Importantly, place orders passively without adjustment once in the trade. This removes subjective feelings from the equation completely. Stick diligently to the trading plan and its rules come what may. Over time, a positive expectancy should result.
How To Avoid Common Mistakes When Using SL/TP?
While SL and TP are cornerstones of risk management, some traders still struggle with various behavioural biases:
- Chasing Losses: Being stubborn about weak positions and moving stops progressively farther to avoid taking the loss. Cut losses short aggressively instead.
- Taking Early Profits: Not letting winners run according to the original system. Resist booking small gains too readily, and let targets be actioned.
- Not Using Stops: Believing self-control is enough but emotional involvement changes perception of the trade. Protective orders are a must for all positions.
- Scaling out of Position Sizes: Rather than a single, risky all-or-nothing trade size, scale in and out incrementally with partial closes to bank profits safely.
By pre-empting these tendencies, traders can stay focused on the execution of their strategy and reach their performance goals over many months of consistent trading. Discipline and patience with the process are absolute requirements for long-term success.
Advanced Stop Loss and Take Profit Strategies
While the basics should not be overlooked, more nuanced approaches can further optimize risk/reward profiles:
Trailing Stops
As winning trades progress favourably, trailing stops dynamically ride the trend higher to lock in increasing profits but cut losses early on pullbacks. Manual or auto options exist.
Multiple Time Frame Analysis
Higher time frames give a strategic macro view while lower frames provide intraday trade entries. Filter trades through converging signals across periods.
Bracket Orders
Use a combination of SL/entry and entry/TP levels to systematically scale into winning positions for a more flexible risk profile.
Swing Vs Day Trading SL/TP
Swing trades held 1-5 days require wider dynamic SL placements versus day trades exiting the same session. Adjust accordingly per style.
Hedging Strategies
Offset long versus short positions in correlated assets to neutralize sector risk through delta-neutral portfolios. Protects against sudden reversals.
Case studies demonstrate integrating such multi-layered approaches in practice. With experience, traders gain a sixth sense of opportunistic exits and entries that amplify returns. But foundations must first be grounded in discipline, preparation and proven basic strategies.
Conclusion
In conclusion, stop loss and take profit orders are not set-and-forget mechanisms, but rather a flexible framework adjusted per market conditions and individual risk tolerance. Their strategic use, whether for short-term scalps or position trades, provides a scientific anchor compared to emotional decision-making.
While not guaranteeing profits, SL/TP placement is an essential habit of consistently profitable traders managing their volatility exposure. Keep testing and optimizing methodology over many backtests and real trades. With ongoing dedication to crafting a robust trading system, and following it with commitment, traders stand to gain substantially from applying this risk management best practice.
Updated:
August 13, 2024 
