Stop Loss and Limit Order

Perhaps the most important tools in any trader’s armoury are the stop loss and the limit order.  If you don’t use them, you really should and if you are new to trading then make sure you read this guide fully – it could save you a lot of money.

The Stop Loss

We will begin by looking at what a stop loss is and an example to explain the concept in practical terms.

An unlikely but possible scenario

Imagine you are invested into a platinum mining company – one that you think is financially secure and has strong fundamentals.  The share price seems stable and is traded in the same range that it has been for the last six months.  Next thing you know, there is a workers strike at the most important mine belonging to the company and the share price loses a quarter of its value instantaneously.

As we know, CFDs are a leveraged product meaning your position is likely to be worth considerably more than the balance you have in your account.  If the above scenario were to happen then you could find yourself heavily underwater, perhaps to an amount that is impossible for you to cover without selling your car or even your house.

This example might sound drastic but it happens more often than you would think… to unlucky people who have forgotten to use, or were unaware of the stop loss.

What is a Stop Loss?

The stop loss is a feature that CFD brokers provide that allows you to predetermine a price where the broker will automatically close your position if that price is reached.  If you hold a stock and could not bear the loss involved if its price dropped by more than 10%, you could setup a stop loss that closes you out if and when it reaches that point

An example:

Company QWERTY is trading at 143-144

John Mills wants to buy 50,000 shares using a CFD in QWERTY as he thinks the price is going to rise but he cannot afford the loss incurred if the share dropped by more than 10%.  He therefore places a stop loss at 130.

Unfortunately (although you could argue he was fortunate)  for John, the price drops by 20% after the company releases far worse than expected profits and declares a pension funding black hole.  The price now is 116.

If john had traded without the use of the stop loss, he would be hit with a £14,400 loss (50,000 x 144p x 20%).  Because he placed the stop loss, he was able to limit his loss to heavy, but manageable £7200.

The Limit Order

A limit order is another highly useful tool that CFD companies provide to their clients.  Again we will discuss what a limit order is and then give an example of how one could be used.

Limit orders works in a similar way to the stop loss except for the fact that it OPENS a contract, rather than closing it at a predetermined level.  It is used by many investors and traders as most financial assets will trade within a range on any given day.  It is therefore likely that a price will decrease somewhat further than where it is at any particular point in time.

An example:

On Monday, Jeff decides he wants to purchase 10,000 shares in Shiny Alloys PLC and the company is currently trading at 200-201.  Jeff has noticed that for the last few days, the price has between the range of 192 and 205. 

Rather than buying in at 201 he considers the likelihood that the price will return, at some point to 195 so he sets up a limit order to buy the contract when it hits this price.

On Tuesday, the price does in fact drop to 195 and the order is filled with the outcome being that Jeff bought the same number of shares but for around 2.5% less than what he otherwise would have.

Summary

As we can see, both the stop loss and limit order are highly important aspects of successful trading.  Anyone that uses CFDs should at least use the stop loss to limit themselves from potential financial ruin.  Although the limit order can be extremely beneficial in the right hands, it isn’t a maker and breaker like its trading sibling.