Risk management is one of the most important things to learn as a new trader. Mastering it will ensure the longevity and success of everything you do in the financial markets. Without a disciplined approach to managing potential losses, even the most well-researched trading strategy can quickly go bad.
A newbie trader might ask, “Why is it so important to understand risk management?” Unlike large financial institutions, retail traders like you often have limited capital. This makes you vulnerable to swings in financial markets. A robust risk management strategy not only protects your capital but also provides a psychological shield. It ensures that your trading decisions continue to be calculated rather than impulsive.
Yes, spotting profitable opportunities is a good skill, but preserving capital is what sets the best traders apart from the rest. In this article, we will introduce you to two important risk management tools – take-profits (TP) and stop-losses (SL). We will also explain how you can use them in trading.
What is a Take-Profit Order?
TPs and SLs are two important features in the world of trading. They are some of the best tools you can use as part of a risk management strategy. A TP is a predetermined price level set by a trader at which they aim to close an open position for a profit. Think of it as a target price that you expect the asset to reach, and once it hits that price, the position is automatically closed. This guarantees that you take a desired level of profit. Yes, the instrument could continue to be profitable after your target price, but inserting a TP means you won’t go chasing riches.
What is a Stop-Loss Order?
On the other hand, a SL is an order placed with a broker to buy or sell once the asset reaches a certain price. This feature is best for limiting your loss on a position. The SL is normally set at a price that is less favorable than the current market price. If the deal doesn't go as planned, the SL order will automatically trigger, closing the position and capping the loss at a predefined amount. If you want to find out even more about SLs and TPs, read our article here.
Where and When Can I Use a TP and SL?
Traders can use TPs and SLs across various financial instruments. This is the best way to automatically lock in profits or limit losses. Here are some of the instruments where these orders are commonly used:
FOREX: This is one of the most popular markets where TP and SL orders are used. FOREX traders can set these orders to protect their positions from sudden currency price swings.
Stocks: Day traders or swing traders on the stock market often use these orders.
Commodities: Whether it's oil, gold, or agricultural products, traders in the commodities market make the most of TP and SL orders to manage their trades.
Futures Contracts: Futures traders can also set TP and SL orders to manage the risks that come with volatile price movements.
Options: While options traders might not use TP and SL in the same way as traders in other markets, they can still set certain price levels to automatically close out positions.
Contract for Differences (CFD): These complex derivative instruments allow traders to speculate on the price movement of an asset without owning the asset itself. TPs and SLs come in very handy during this activity.
Cryptocurrencies: This is one of the most volatile trading assets out there. Traders frequently manage their risk in cryptocurrency markets with TPs and SLs.
Exchange-Traded Funds (ETF): Just like with stocks, ETF traders can set these orders to automatically close positions at predetermined levels.
Bonds: This activity might be less common than in some other markets, but bond traders can also use TP and SL orders, especially in electronic trading platforms.
The Importance of Risk Management and The Role of Emotion in Trading Decisions
Here at Arincen, our experts understand that emotions like fear, greed, hope and regret can significantly influence your trading behavior, and not always in a good way. Fear can make you sell off assets prematurely during a market downturn, potentially missing out on rebounds. On the other hand, greed can make you hold onto positions for too long, only to see gains diminish or turn into losses.
How TP and SL can help curb emotional decision-making
TP and SL orders can counteract the dangers of emotional decision-making. By setting predetermined exit points, both for potential profit and acceptable loss, traders establish a clear framework for their trades, which acts as a barrier against the whims of emotional impulses. A TP ensures that profits are secured at a specific target. Conversely, an SL provides a safety net, ensuring that in the face of adverse market movements, losses are capped at a level the trader is comfortable with.
The Importance of Preserving Capital in Trading
For the newbie trader, preserving capital is vital. Here's why:
When starting out, a trader's primary capital is both their lifeline and their tuition. In the ever-evolving world of trading, mistakes are inevitable, especially in the initial stages. Preserving capital ensures that new traders have the leeway to learn from these mistakes without being completely sidelined by them.
Preserving capital ensures longevity in the trading arena. The longer you are in the business, the more experience you gain.
Trading, especially in its early stages, can be as much a psychological challenge as it is a technical one. Experiencing substantial losses can be emotionally taxing and can erode confidence. By focusing on capital preservation, newbie traders can maintain a more stable emotional state, which is crucial for making rational decisions.
Determining When to Use TP
There is a skill to deciding when to use a TP. When traders first start, much of what they do is based on guesswork. This is completely normal and expected. As you gain more experience, you get to grips with using additional tools, like technical analysis, to help support your decisions.
Some people liken trading to trying to predict where a ball might bounce or stop rolling on a playground. To do that, traders often use previous patterns they have seen before. They apply this technical analysis to determine important markers such as “support” and “resistance” levels of a financial asset. These are its lowest and highest levels, respectively. By watching these patterns and using these tools, traders set their profit targets, deciding when to buy or sell to make the most money.
The role of fundamental analysis in setting TP
While technical analysis is all about studying past data, you can think of fundamental analysis as the "health report" of a stock or an asset. Fundamental analysis looks at big news like economic announcements or how much profit a company makes. If a company announces big profits or if there's positive economic news, the stock might rise. So, traders use this information to set their TP points. For example, NVidia is a stock in the news right now as it is posting record earnings based on the rush by industries to adopt artificial intelligence. If you weren't paying attention to the news, you would not know when to back this stock.
Psychological price points and their impact on TP levels
Imagine walking into a store and seeing a price tag of $9.99 instead of $10. Even though it's just a penny less, it somehow feels like a better deal, right? This is due to psychological price points - prices that feel more attractive or significant to us.
In trading, these psychological points, like round numbers, are often where traders decide to take their profits. For instance, a stock approaching $100 might see a lot of traders setting their take-profit right below this level. This is because it's a big, round, and memorable number. Humans as very much alike in these types of preferences. So, in the same way that a $9.99 price tag brings in shoppers, these psychological levels in the market can attract traders and influence where they decide to cash in.
Types of SLs
While there is really only one way to take profit, there are multiple ways to insert a SL:
Hard SL: A firm price level
A hard SL in trading is a firm price level where you've decided in advance that you'll sell your stock or asset to prevent further losses. No second-guessing, no waiting—once it hits that set level, you're out. It's a trader's safety net, ensuring they don't stay on a financial ride that's getting too wild for their comfort.
Trailing Stop: Moves with the price in a profitable direction
A trailing stop is a way to let your profits run, while still having a safety mechanism to guard against major losses. As your investment or stock price climbs, the trailing stop adjusts and moves up with it, securing your gains. But if the stock price starts to drop, the trailing stop acts as a limit, automatically selling your stock before it drops too much.
Mental Stop: Based on trader's discretion, not placed with the broker
A mental stop is another one of those human shortcuts we like to use. A mental stop is a point at which a trader decides they'll sell an asset if its value drops to a certain level. However, unlike other stops, this isn't necessarily set on the broker’s platform. Instead, it's based on your personal judgment. There is a risk to doing this as you must then manually make the sale when that point is reached. This type of approach is mainly for active traders who have the self-discipline to remember when to sell up.
The Pros and Cons of Using TP and SL
Emotional Buffer: TP and SL orders help take the emotion out of trading decisions. It gives you a systematic approach that reduces impulsive reactions based on fear or greed.
Risk Management: SL orders limit potential losses by automatically selling an asset when its price drops to a certain level, ensuring that you don't suffer major financial setbacks from a single trade. Risk management is a crucial way to extend your trading career.
Profit Locking: TP orders allow traders to secure profits automatically when a price target is achieved. This way, gains aren't eroded if the market shifts in the opposite direction.
Efficiency: Both orders allow for automated trading, meaning positions can be closed even if you are away from your screen. This ensures that even in fast-moving markets, you can safely take your eye off the trading screen for a while.
Premature Exits: Market volatility can trigger an SL or TP prematurely, potentially causing a trader to miss out on further profit or exit a position before a potential rebound. This happens fairly frequently, and traders kick themselves when it happens, but these are the ebbs and flows of trading.
No Flexibility in Real-time Analysis: Once you have set them, TP and SL might prevent traders from taking advantage of changing market conditions or new information that affects a market price.
Slippage: This is an important facet to remember about volatile markets, like FOREX and cryptocurrencies. The actual execution price of SL or TP orders might differ from the set price, leading to unexpected losses or reduced profits.
Over-reliance: It’s easy to develop an over-dependence on these orders and neglect keeping a pulse on the market and educating yourself.
False Security: Some traders may feel overly protected by these tools and engage in riskier trades than they otherwise would, believing they have a safety net in place.
While TP and SL orders offer essential tools for risk management and strategy execution, how well they work really depends on accurate application combined with broader trading strategies.
Common Mistakes and How to Avoid Them
While TP and SL are invaluable tools for traders, they are not perfect. A successful trading strategy incorporates these tools while also allowing for flexibility and continuous learning. You still need to be able to think on your feet. Here are some common errors:
Setting Stops that Are Too Tight: One of the most common mistakes, especially among new traders, is setting their SL levels too close to their entry point. Often, this results in your position being closed too early in response to normal market volatility, even if the overall trend is in the trader's favor. It’s a newbie trap that you can only get out of with more trading experience.
How to Avoid: You should ensure your SL is set at a level that gives the trade some room to breathe. This might involve analyzing the average volatility of the asset and setting the SL a little further than that.
Neglecting to Adjust: As a trade becomes profitable and moves in the desired direction, some traders forget to adjust their SL to protect their gains, leaving them vulnerable to market reversals.
How to Avoid: This is a textbook occasion to use a trailing stop, which moves with the price in the profitable direction, automatically adjusting the SL level as the price moves favorably.
Setting Arbitrary Targets: Sometimes traders set TP levels based on desired profit amounts rather than actual market analysis. This happens more frequently than traders like to admit. This can either cut profits short if set too low or leave you waiting for a target that the market has no real reason to reach.
How to Avoid: Base your TP levels on sound technical or fundamental analysis. Look for logical points of resistance or potential market turnarounds rather than pie-in-the-sky profit numbers.
Ignoring Major News Events: Economic announcements or significant company news can lead to sudden and drastic market movements. If you are not ready, these can sweep past TP or SL levels.
How to Avoid: Always be aware of the economic calendar and major news events. Consider widening SL or TP levels during these times or avoiding trading altogether.
Over-relying on Mental Stops: While mental stops can be useful, relying solely on them can be problematic. Emotional biases can prevent you from executing your exits when the predetermined level is reached.
How to Avoid: Use actual SL orders whenever possible. They enforce discipline and ensure you stick to your trading plan, even when emotions run high.
Not Re-evaluating: As time passes and more information becomes available, the initial TP and SL levels may no longer be appropriate. Sticking rigidly to old levels can hurt you.
How to Avoid: Continually reassess your positions when presented with new data. As the market landscape changes, so should your targets.
TP and SL orders are two of the most crucial steps for traders, offering a structured approach to maximizing gains and reducing losses. Yet, as with any powerful tool, how well they work is not only in how they are used but in their consistent application. The nuances of setting, adjusting, and re-evaluating these orders can mean the difference between flash-in-the-pan success and sustained profitability.
By understanding the intricacies of TP and SL, and by sidestepping common pitfalls, you not only safeguard your capital but also master the art of trading with accuracy and foresight. This is one of the best ways to have a long and fruitful trading career.
What is the primary purpose of using TP and SL in trading?
The primary purpose of TP and SL is to manage risk and secure profits. TP allows traders to lock in a specific profit level, while SL sets a maximum loss that a trader is willing to take, automatically closing the trade once that level is reached.
How do I determine the best levels for my TP and SL?
Setting TP and SL levels requires a combination of technical and fundamental analysis. Consider support and resistance levels, historical price movements, Fibonacci retracement levels and current market news. It's also vital to factor in your risk tolerance and trading goals.
Can I adjust my TP and SL levels after placing them?
Yes, TP and SL levels can be adjusted after they are set, depending on how the market evolves and if new information becomes available. It's essential to maintain flexibility but avoid adjusting levels purely based on emotions.
What is the difference between a hard SL and a mental stop?
A hard SL is an order placed with a broker to sell an asset once it reaches a certain price. A mental stop, on the other hand, is a predetermined price level decided by the trader but not set as an official order with the broker. While hard stops ensure automatic execution, mental stops require manual action and discipline on the trader's part.
How does market volatility affect TP and SL?
In highly volatile markets, prices can swing widely in short time frames. This can lead to TP or SL levels being hit prematurely. To prevent being stopped by short-term fluctuations, traders might consider wider SL ranges during volatile periods, while still being mindful of their risk tolerance.
Should I use a trailing stop instead of a fixed SL?
A trailing stop is a type of SL that moves with the market price in a profitable direction, providing protection while also allowing for potential profit. Its use depends on trading strategy and market conditions. Traders who believe there's potential for continued price movement in their favor might opt for trailing stops, while those seeking fixed risk levels might choose fixed SLs.
How can I avoid premature TP and SL activations?
Avoid setting TP and SL levels too close to the current market price, which can result in premature activations due to regular market fluctuations. Use a combination of market analysis, historical data, and an understanding of current market sentiment to set more informed levels. It's also crucial to continuously monitor and adjust as necessary, especially during significant news events or market shifts.
Adrian Ashley is a seasoned business and finance writer. With a corporate career spanning over 20years, he has developed deep experience in such diverse areas as investing, business, finance,technology and macroeconomics. He is passionate about captu...