As a trader in any financial market, one tool you must familiarise yourself with is stop loss. Financial asset traders and investors make stop loss their companion and so should anyone trading digital assets; an asset class that tends to be notoriously volatile. In this article, we will discuss stop loss, and the types that can be used in different scenarios depending on the crypto market situation.
What is stop loss and when is it used?
Stop loss is a feature built-in to most of the advanced cryptocurrency trading exchanges to help prevent further losses on a trade. It’s a no-brainer that traders engage in the daily activities for a singular purpose - making profits and cutting down on losses.
As an order tool, once set by the trader, it triggers, automatically liquidating digital assets once the preset conditions are met in any particular open trade.
There are different types of stop loss whereby each can be deployed based on any particular market condition. There’s a myth in investment communities that the stop loss tool is for inexperienced traders and that “veteran traders” with years of experience under their belts do not have a need for it. Sometimes it may be somewhat difficult to avoid losses due to the varying possible market outcomes, but stop loss can be helpful for both new and experienced traders.
One striking difference between a stop loss and a limit order, which aims to profit from the current trends, is that traders only use a stop loss order to limit potential losses to their allowable threshold for trading losses.
This is not only a step towards maximising profits, it also expands the trader’s options for strategising, by increasing their control of the trade’s risk factor. For stop loss to be used effectively, the trader still needs to predict the direction where the market might swing towards and tailor the stop loss accordingly. If not, the stop loss might not only fall short of preventing losses, it could end up multiplying the losses further. Once the trader has an idea of how the market will behave, they must choose both the value and type of stop loss order they wish to use.
Types of stop loss
Full stop loss: Liquidates all crypto assets when triggered. This is useful in a stable market with sudden unexpected price fluctuations, so that any price drop is predicted to remain low. While a surge backup will mean the trader loses out on potential profit, they will have avoided a loss if the price of crypto remains low.
Therefore, when setting a full stop loss, the trader must consider the risk and reward of both scenarios.
Partial stop loss: Liquidates a specified proportion of the digital assets when triggered. This can be useful in a highly volatile market (i.e. cryptocurrency market) to ensure the trader still has some assets remaining if the price drops before a surge. However, it leaves the trader with potentially unwanted assets, and if the price stays at a low level they will remain at a loss. This can be effective as an instrument of damage control in a highly volatile market, but it cannot guarantee the safety of the trader’s assets. It must therefore be used with the full understanding that the risks remain high.
Trailing stop loss: The stop loss value will adjust according to the crypto asset’s price fluctuations. The trader sets a trailing distance, which is the difference between the current asset price and the stop loss value. If the price of the cryptocurrency rises, the stop loss value will rise with it. When the price drops, the stop loss value will not change and a stop loss order will be triggered if the stated value is reached.
This has an advantage over set stop loss orders since it allows the trader to cap the maximum loss regardless of how far the trends have gone in their favor. What’s more, this frees the trader from having to manually adjust stop loss in response to the market. Trailing stop loss may become a liability in a steadily rising market, as strong rising trends often drop before continuing to grow. A low trailing distance could therefore result in the assets being liquidated before the price has reached its upper limit.
Associated risk factors for adopting the types of stop loss
If full stop loss orders are set too high, the trader risks losing out on a price surge beyond the stop loss value. This is highly likely in a volatile market.
The trader risks losing out if the stop loss value is too low so the price drop doesn’t trigger it but then hits a steady trend after dropping. If the stop loss is triggered, the trader will lose more with a low stop loss value than with a high one, although it may have been a better choice if the trader believed the market would go back up after a drop that didn’t trigger stop loss.
While seemingly safer in a stable market, trailing stop loss is a potential liability in strong upward trends. Partial stop loss is of little use in a stable market but can be of great help when trading with highly volatile new coins. That said, all risk comes with poor choices regarding the type and value of stop loss due to incorrect market analysis—much like any trading tool that can be damaging if not used properly.
Stop loss in futures trading
When trading using leverage on Futures or Margin exchanges, the trader does that with borrowed funds, sometimes with up to 100X leverage. It becomes highly risky trading with leverage without stop loss as the trader’s account may become entirely liquidated especially with the volatile nature of cryptocurrencies.