Make sure to use stop-loss orders when trading options online, regardless of your skill level or experience in trading and investments. Introducing stop-loss orders into your trading routine can help you minimize potential losses and keep more of your capital over time. Stop-loss orders are critical to traders because they are an effective risk management tool that comes in handy when the market can be completely unpredictable.
Our guide will explore how stopping-loss orders can save you from significant losses and ensure better trading discipline. Not only will we highlight the benefits of using these tools, but we’ll also share the different types of orders you can implement and some of the best ways to implement them to avoid common trading mistakes. You’ll find quickly that stop-loss orders are a game-changer regarding how closely you monitor the market. These automatic orders make it so you don’t have to monitor your investments 24/7—it’s all done for you until you need to make an adjustment to the order!
What Is a Stop-Loss Order?
To understand why stop-loss orders are so crucial in options trading, it’s important to know what stop-losses are and how traders and investors can use them to keep a healthy and balanced portfolio of options. This section of our guide will define stop losses, how they work in regular, everyday options trading, and the types of stop loss orders you’ll encounter during a standard options trading session.
Definition: Stop orders are a risk management tool where traders or investors have securities sold from their portfolios automatically when they reach a specific price. The purpose of stop-loss orders is to limit losses, specifically in situations where traders want to sell securities below market price if the price drops unexpectedly.
How It Works in Options Trading
After setting the stop loss (usually below their entry price), the stock’s price eventually reaches the stop price, and the order transforms into a market order. The order then sells the positions automatically at the best available price. When traders set this predetermined price level to exit a trade automatically, they limit how much they will lose on every trade they engage in.
Types of Stop-Loss Orders
There are several kinds of stop-loss orders that traders or investors can choose from. The traditional stop-loss order (stop order) closes out a trade if the market price hits the specific price the trader sets (the stop price), helping to limit losses if the market moves against the trader.
- Trailing Stop Loss Orders: These orders are activated when a predetermined profit level is reached. They move in the same direction as the asset price and can be used by traders and investors who want to protect their profits. Once the stop order is set, it will move up as security prices increase, or it will remain in place if the price decreases. The order “trails” market movement.
- Cover Order: A cover order is a buy or sell order that’s placed along with a mandatory stop loss over a specific price range. It reduces risk and lets traders or investors leverage their positions more efficiently.
- One-Cancels-the-Other (OCO) Order: This order combines a stop-loss market order and a limit order. It consists of a limit price and a trigger price. Traders place these orders above and below the breakout point to ultimately profit from volatility in pricing.
- Stop-Limit Order: Traders can control a trade’s price using these orders. They consist of a stop price at which the order is triggered to convert a sell order and a limit order that executes when the market price reaches or exceeds the limit price.
The Risks of Options Trading Without a Stop-Loss
Stop losses are a familiar strategy traders use to manage risk and reduce potential losses effectively. Stop-losses were designed for traders and investors to get around the dangers of trading without using these orders. This section will cover the primary risks of trading and investing without these automated systems. You’ll work stop-losses into your trading routine after seeing how many downsides there are to not using them at all!
High Volatility
It’s not impossible to trade without stop-loss orders, but it’s not recommended, especially for new traders still learning the ropes. The options trading market is subject to price swings, known as market volatility, which can cause newbies to miss out on prime trading opportunities or suffer significant losses. However, using stop losses can take much of the monitoring work out of trading and ensure that no options, stock, or other position lose any more money than the trader is comfortable with.
Potential for Large Losses
Not using stop-loss orders could lead to bad trades and significant losses if the trader or investor doesn’t keep a close eye on the market. For example, someone might not be comfortable with losing more than $30 on a trade, but if they aren’t using stop-loss orders, they must constantly monitor the market to ensure the trade doesn’t lose more than $30. There’s a situation where a trader may miss a price drop this significant, especially if they’re tracking other investments in their portfolio. This could lead to bigger losses than the trader bargained for when they could have just set up a stop-loss order to manage this.
Emotional Trading
Setting up stop-loss orders isn’t just getting trades to sell automatically to make things more manageable for the investor and minimize losses. It also involves keeping a good grasp on your investment budget, correctly allocating the right funds to the right trades, and pulling out of losing trades at the appropriate time.
Not setting a stop-loss can lead to emotional, irrational decisions and further losses. Trading without these orders can signal that the investor didn’t take the time to plan out how much risk they’re willing to take on each trade before pulling out altogether. Without a trading plan or goals, many trades will find themselves going in on hyped-up trades or choosing positions based on thin evidence that they will perform strongly. It can lead new, inexperienced investors to select a lot of bad trades and then not get out of them as quickly as possible.
Benefits of Using Stop-Loss Orders in Options Trading
We’re a big proponent of using stop-loss orders. It only makes sense, especially if you have a portfolio with a lot of trades and positions to manage. This section of our stop-loss order guide will go into more detail about the multiple benefits that await investors and traders, such as how to work stop-losses into their trading sessions and stay on top of adjusting them with fluctuations in the options trading market.
Automatic Risk Management
Setting up stop-loss orders helps you manage risk with your options portfolio, and you don’t even have to worry or think about it unless you want to adjust the stop-loss limit. These orders are super helpful for automatically limiting potential losses—it’s all done based on how much money you’re comfortable potentially losing on each trade.
Discipline and Planning
There’s nothing better in options trading than developing a sound strategy and staying committed to it throughout each trading session. Part of a trading plan involves outlining the amount of money you’re willing to take as profit with each trade and how much you’re comfortable with possibly losing. These stop-losses can help you stick to your trading plan, maximizing profit and limiting losses.
Peace of Mind
Setting up stop-loss orders means you don’t have to constantly check the market to ensure all your traders are executing at the correct sell prices. Traders can kick back and not worry about monitoring every small detail of their portfolios. Having the stop-loss orders in place helps give traders or investors peace of mind.
Types of Stop-Loss Orders in Detail
From the way we’ve been describing stop-loss orders, one might think that there’s one type of standard stop-loss that all investors or traders use to limit losses and lock in profits. In reality, a few types of orders work well for different situations and trading environments.
Traditional Stop-Loss
The traditional stop-loss order is placed when traders or investors want to buy or sell a security once it has reached a specified price (the stop price). It is used to limit losses and protect a position from a sharp decline in the stock’s price. After the stop price has been reached, the stop-loss order becomes a market order, and it is executed at the current market price.
- Select the number of shares you’d like to sell.
- Choose a stop price that’s lower than the current market price.
- Next, place your stop-loss order on your trading app of choice.
Trailing Stop-Loss
The trailing stop-loss “trails” the security’s price where the stop is set at a specific distance from the current market price. Trailing stops focus on the stop loss being set to a particular percentage below an asset’s price instead of being put on a single value. It’s designed to lock in profits or limit losses as the trade moves in a favorable direction. Something called “unrealized gains” is accounted for in trailing stop losses, and we’ll shed more light on this in an example below.
Unrealized Gains’ Example
Let’s say a trader bought a stock at $10 per share. They could implement a traditional stop loss where the order sells once the price stops down to $9 per share. Or they could make a trailing stop loss for 10% below market price, and this is because the stock price could rise, resulting in unrealized gains.
In this scenario, the share price could go from $10 to $15, meaning the trailing stop loss would rise to $13.50. $5 is your unrealized gain because the share price went from $10 to $15. If the stock price dropped to $13.50 with a trailing stop loss of 10%, the position would automatically be sold off, locking in the profit of $5 in unrealized gains.
Stop-Limit Orders
Stop-limit orders are a combination of a limit order and a stop order where investors can have greater control over the price where the trade is executed. The approach to using a stop-limit order is to avoid selling shares at a significant loss if the price unexpectedly drops and avoid closing position prematurely if the price doesn’t reach its limit. An excellent example of a stop-limit order in action would be a trader setting an order to sell shares at $80 if the price falls to $85 or below. If the price doesn’t fall to $85 or lower, the order isn’t triggered, and the investors or traders get to keep their shares. In the event the stock drops to $85 or lower, the shares will be sold automatically for $90 per share.
How to Set Effective Stop-Loss Orders in Options Trading
Setting up the proper stop-loss orders isn’t a situation where a single approach can be used in every situation. Stop-loss limits are based on several factors and can change from one investor to another. These factors include investors determining their risk tolerance, setting the right level based on market conditions, and making appropriate adjustments to those levels based on how their trading experience online unfolds.
Determine Your Risk Tolerance
Your risk tolerance depends on your personal appetite for risk and how much capital you have at your disposal. A lot of it depends on your age and your ultimate investing goals. For instance, if you’re younger, you have a longer time horizon, and you can, therefore, take a few more risks compared to someone who is approaching retirement and can’t afford to gamble with their investments in the same manner.
If you have investment goals like saving to buy a home or start a business, you might not want to take big risks. Traders or investors who have an interest in online investments and want to learn how they work without firm investment goals can afford to take some higher risks (within reason).
Setting the Right Price Level
There are three primary factors to consider when setting the price level for a stop-loss order: your trading goals, the types of investment you’re making, and your personal investment style. Trading goals include whether you want to control your trade’s price or have your stop-loss order fulfilled quickly. The type of investment you choose is either a long or short position. Your personal investment style depends on whether you’re an active or long-term trader.
Follow these general guidelines and best practices to setting the right price level for your stop-loss order:
- Place your stop price below the current market price. This is intended to keep your potential losses to a minimum.
- Set your limit price at the stop price or below. Ultimately, it’s best to set the order at the price you’re willing to accept.
- To prevent too much downside risk, use a stop-loss percentage where the stock price fluctuates slightly.
Adjusting Stop-Loss Orders
If you’re using a trailing stop loss order, the order automatically tracks any price improvements, letting traders take advantage of any unrealized gains. The trailing stop keeps the order within a certain percentage of the current market price to lock in profits. However, investors who don’t use the trailing stop-loss order will have to manually adjust their stop-loss orders to match the changing market, that is, investors who are staying on top of the action.
For example, if you bought shares at $100 and have a stop loss set up for $90 because you don’t want to lose more than 10% of your total investment, you might consider adjusting your stop loss upward if there’s a significant price improvement. If the price increases to $150, the trader might want to change their stop-loss order to $135. This way, the investor locks in unrealized gains, and an order executed at $135, in this case, would be the 10% loss that the trader is okay with incurring.
Common Mistakes to Avoid When Using Stop-Loss Orders
Making mistakes when setting up stop-loss orders can cause traders and investors to experience losses on bad trades or miss prime opportunities. Now that we’ve outlined the best practices associated with stop-loss orders avoid these common mistakes when setting up stop-loss orders during your trading sessions.
Setting Stop-Losses Too Tight
Because market fluctuations can move the price of options severely in one direction or the other, it’s best not to set stop-loss orders too closely to your entry point. It can lead to your order being triggered sooner rather than later, resulting in missed opportunities because the trade hasn’t had enough time to grow with time.
Not Considering Market Volatility
Market volatility should be a top consideration when trading options, especially when setting stop-losses. In volatile market situations, it’s best for the stop loss to be placed far from the current price but not too far where you take more loss than necessary. If the markets aren’t expected to be too volatile, placing the stop price closer is safe but not so close that you miss out on a potential market reversal.
Ignoring Adjustments
Another common mistake with stopping losses is setting them and never adjusting them to keep current with changing market conditions or significant changes in your capital. Not changing your stop loss limits can result in missed profit opportunities or substantial losses.
An example of this would be a trader neglecting to adjust their stop-loss limit after a stock performs well and rises. If the stock drops unexpectedly in price, it could trigger a stop-loss order that results in a much larger loss than the traders anticipated. A trader who takes the time to notice this change and adjust their limits to reflect the higher stock price would be able to limit their losses and also allow the trade room to fluctuate in the event of a price dip.
Real-Life Example: How Stop-Loss Orders Can Save You Money
At their core, stop-loss limits are designed for traders to save money by locking in profits and minimizing potential losses by capping risk. Let’s look at a real-life example of a trader setting up a stop-loss order to avoid getting involved too heavily in a trade that could go south. Find out how you can cut and run when a trade begins trending downward, freeing up capital to use on more profitable trades.
Case Study/Scenario
Let’s look at a hypothetical scenario where a trader uses a stop-loss order to minimize losses:
The trader in our example plans to invest in shares at $100 and not lose more than 10%. They want to set up a stop loss because they have many other trades to manage, so they don’t want to miss out on selling these shares if the price dips to $90 or below (the stop price ensures that the trade sells if it hits this number).
Let’s say the market dips down to $90. It makes no difference if the trader is paying attention to their trade or not—the stop loss order will be triggered when the stock price hits $90, and it will sell automatically, ensuring the trader doesn’t incur more than a 10% loss. Applied to every other position in their portfolio, investors and traders can significantly limit their losses, ensuring they don’t lose a ton of capital on bad trades.
Contrast Without a Stop-Loss
We highly recommend trading using stop-loss limits because you’ll have to watch the market like a hawk to keep track of your investments. If you want to trade without these orders, it’s entirely up to your discretion, but there’s a good chance you’ll drop the ball and either miss out on locking in profits or limit your losses.
Missing Out on Profit
If you don’t implement a trailing stop loss order, you can miss out on unrealized gains when the stock price goes up, but you don’t have an automated stop order that sells your positions if the market takes a slight dip. You would have to view the market closely to spot a potential downturn that would suddenly go below the percentage you’re comfortable with losing on the trade. Then you’d have to manually sell the shares when you could have set up a trailing stop that would have locked in the profit and automatically performed the sale for you.
Missing Out on Loss Limit
If you aren’t using a stop-loss order, the stock price may fall below what you’re comfortable losing. Unless you have a lot of time on your hands and are ultra-vigilant in checking the market, there’s a good chance you’ll miss these dips if you’re managing other positions in your portfolio. You would incur a larger loss than necessary when you could be using a stop loss that does the entire thing for you without worrying about it too much.
Key Takeaway
Managing an entire portfolio of options can take a lot of mental energy, and it’s best to use stop-loss orders to remove some of that burden. You don’t have to think about it too much once you’ve set the limits of how much you’re willing to lose with each trade. These orders will execute your wishes. Trailing stops help to lock in profits while also limiting losses. If you aren’t using a trailing stop-loss order, you do have to monitor the market to make possible adjustments to your orders to ensure you’re keeping up to date with significant changes in the market.
Pros and Cons of Using Stop-Loss Orders in Options Trading
Stop-loss orders can be one of the most helpful tools for investors to manage risk and keep their losses to a minimum, but there are some drawbacks to using stop-loss orders and relying too heavily on automated systems to take care of everything.
Pros
- Automated Risk Management—Once you have set up the stop loss limits, your trades will automatically sell off once they hit the specified limit. You only have to worry about keeping an eye on these limits when there’s a significant market change, which justifies an adjustment.
- Helps Maintain Trading Discipline—Using stop loss limits helps traders stay committed to their trading plan. Automation streamlines the experience and holds traders accountable for their investment goals.
- Reduces Emotional Decision-Making—With the stop loss orders in place, this takes some of the emotional decision-making aspects out of a trading session. The automated system will execute these trades automatically. You don’t have to make decisions based on fear of loss, fear of missing out, pride, overconfidence, etc.
Cons
- Possibility of Premature Trade Exit Due to Market Fluctuations—If you fail to either set your stop-loss limits far enough away from the entry price or you don’t use the trailing stop-loss order, there’s the chance that a market fluctuation will trigger your order too early, which doesn’t allow enough time for the stock to grow in value.
- Risk of Slippage—Slippage occurs between when an order is placed and when the trader executes it. This can lead to market orders being executed with a stop loss and closing the positions at a rate different than set in the order.
Best Practices for Using Stop-Loss Orders in Options Trading
Stop orders are well known for helping traders gain better control of their trading objectives, but this is only possible when traders implement the best practices we outline in this next section. Use stop-loss orders, but use them effectively for maximum impact on your investments and the health of your portfolio.
Combine with Other Risk Management Strategies
Using stop losses can be helpful for traders who want to lock in profit at the correct times and minimize their potential losses. Still, these orders are best used with other proven trading techniques like diversification and hedging. On top of using stop-losses to ensure you never miss a beat in trading, you also want to choose a diverse set of options to form the basis for your online portfolio and to have money in multiple investments to minimize the impact of trades when they don’t work out.
Stay Informed
Part of keeping your stop-loss orders current with market changes is staying up to date on market news and trends that could affect these strategies. Traders can download apps to get timely updates on market news, and many investment or trading apps have alerts that users can program to ensure they stay on top of any significant changes.
Regularly Review and Adjust
The market is bound to evolve daily, so reviewing your stop-losses and making appropriate adjustments to reflect these changes is best. Take the time to periodically review stop-losses to see if you should change anything, like moving the stop price further away from the current price to avoid a premature trigger or moving the stop price up further toward the current price if the market moves favorably. Your stock makes considerable gains in price.
Use Stop Loss Orders to Simplify Your Trading Process
We cannot emphasize enough the importance of stop-loss orders in managing risk in options trading. The stop-loss order helps a trader maintain self-control and execute their trading plan using the take-profit and stop-loss limits they prefer. We encourage anyone reading this to start implementing stop-losses if they haven’t already and to practice proper risk management.
Explore more of our educational resources on OptionsTrading.org. In addition to learning about setting up stop-loss orders in your trading accounts, you can learn more about some other essential elements of trading options online.
