A stop loss order is a type of order whose purpose is to limit your risk of loss on a trade. It tells your broker to close your position when it reaches a specific price. Protective stop, stop loss or just “stop,” are other ways this order is referred to. It can be used on both long and short trades (i.e. sell stop for a long trade and a buy cover stop for a short trade). Although stop orders are mostly used to exit trades, they can be used to enter trades. They are called buy stops.
The goal of a stop is to keep your losses small while not getting whipsawed out of trades. Where to place a stop is a delicate balancing act between setting the stop too far, and incurring greater losses, and too close, and getting stopped out and then the market reversing. Your job as a trader to find the middle ground between setting the stop to tight, and getting continually stopped out from the market noise or gyrations, and setting the stop to loose, and although you avoid the noise, you incur larger losses.
Why is it important to limit your losses through the use of a stop? The reason is that the larger your loss, the harder it is to recover from. Look at the table below:
If a security Loses X% it has to Gain X% to break even
|Loss||Gain Required to Break Even|
So what does the table illustrate? If your trade drops by 5%, it has to gain 5.26% to get back to even and if it drops by 20%, it has to gain 25% to get back to even. Now for the real pain. If the trade drops by 50%, it will have to gain 100% to get back to even. I won't even discuss trades that drop by more than 50% as those are trades that make you want to jump out a window. So what's the bottom line? A stop should be used by EVERYONE on EVERY trade. Period. If you want to make money in the markets, you have to learn to control your losses. The way you limit your losses by placing stops. Never, never, never allow a trade to lose more than 25%. Think about it. How many trades have you actually gained more than 34% on?