Three stop losses to protect profit

THE markets are going through a volatile period, offering opportunity to spread betters, but also dangers. Traders should not be deterred by the risks but this is a good moment to revisit the tools that can help. Stop losses are an essential insurance policy, guarding against runaway losses if the market suddenly swings against you.

A stop loss kicks in at a predetermined price and stops the trader losing money if the market keeps moving in the wrong direction. There are three main variations: normal, guaranteed and trailing stop losses. All three – by virtue of being fixed in advance – protect against the trader’s emotional attachment to the bet, or distraction at the crucial moment.

A standard stop loss allows spread betters to tear themselves away from their computers, confident that if the pre-agreed limit is hit, the provider will be triggered into selling on their behalf and closing the position. Providers say no trade should go without some sort of stop in place.

The stop loss should be set at an amount that you are prepared to lose. Manoj Ladwa, a senior trader at ETX Capital, suggests determining the stop loss’s level by considering the most extreme position the stock has reached. This will depend on your time frame. For example, if you only plan to hold the stock for a few hours then look at a position just outside the stock’s short term volatility, but if you want to hold on to it for a week or so look at it over a longer period.

In the current climate of mergers and acquisitions, the disadvantage of a standard stop loss is that it is not guaranteed. For example, a trader who went long on BHP might have suffered after the announcement of the hostile bid for PotashCorp, in the event that the provider struggled to find a buyer on their behalf. A guaranteed stop loss, however, forces the provider to take that risk upon themselves, closing the account instantly at the agreed limit.

Guaranteed stop losses buy added safety at a price, costing more money to enter into. Ladwa says: “Having a stop loss in place is vital, but generally speaking it doesn’t pay to have a guaranteed stop loss on currencies, unless you’re trading off uncertain figures.”

In general professional traders rarely use them. Some prefer the trailing stop loss, which follows the market as it changes, allowing traders to lock profit in whilst holding on for further gains (see chart, right). Ladwa says the trailing stop loss is useful because it “tends to take you out of the trade naturally”.

Stop losses were one of the keys that helped unlock spread bets to the mass market. IG Index explains that these tools allowed the industry to evolve from a niche pursuit of City experts, too risky for the amateur to experiment with.

Across the industry most entry level packages now come with guaranteed stop losses built in, with traders only able to ditch them if they qualify for a premium package. IG Index’s version, the Plus Account, offers the trailing stop loss tool.