How to Manage Trading Risks using Stop Losses and Take profit

[TL; DR]

Stop loss and take profit orders are tools to manage trading risks.

Stop loss and take profit help traders to avoid using emotions when making trading decisions.

Traders can use moving average, average true range as well as support and resistance levels to set stop loss and take profit orders.

Introduction

Skilled crypto traders should possess the ability to time the market if they are going to trade profitably. Their ultimate goal should be to enter and exit trading positions on optimal points. Stop loss and take profit levels can help traders to mitigate the risks they encounter when trading cryptocurrencies.

Stop loss - Amanahadvisor

What is stop loss?

A stop loss is a trading tool which automatically closes a position when the price of the asset falls to a certain level. On the other hand, a stop loss level is a preset price , set below the market price, at which point the trading system automatically closes the order.

Basically, a stop loss caps the loss which you may incur if the price of the asset drops. As such, it is a risk management tool that every savvy trader should use.

As an example, a trader opens a long position for an asset with a market price of $10 and sets a stop loss at $8.00. Therefore, if the price of the asset falls to $8.00, the trade will automatically close. In this case, the trader has incurred a loss of $2.00. More importantly, the stop loss prevents a large loss if the price falls further.

Why should crypto traders use stop loss orders?

The basic reason for using stop loss orders is to minimize trading risks. This is because a stop loss reduces the amount of loss you make from your trading activities. As such, the trader maintains a certain amount of money to continue with his/her trading business.

Another compelling reason for using stop loss orders is that you will not micromanage your trades. Once you set your stop loss you wait for its execution.

Limitation of stop loss orders

Oftentimes, the system can execute a stop loss order after a short-term price fall which is, however, followed by a quick recovery that thrusts the value of the asset into a medium-to-long term profitable zone.

What is take-profit?

A take profit order is a trading technical indicator which automatically closes a trade when the price of an asset attains a predetermined level which is above the current market price. A trader, usually, sets the take profit level when he/she enters a trade.

Let’s consider an example to make it clear. A trader who opens a trade when the price of an asset is $10 and anticipates it to rise to $16 can set a take profit level at that point. Therefore, if the price of the asset rises to $16 the trading system automatically closes the trade.

Using risk-reward ratio to manage trading risks

A trader who has an established risk-reward ratio finds it very easy to set both the stop loss and take profit levels. For instance, a trader that uses a risk-reward ratio of 4:1 is willing to risk 25% of his/her capital in order to attain his/her target profit.

Setting profit loss levels

There are several methods one can use to set profit loss levels.

Using price action to set stop losses

Most traders place the stop loss just above the parent pin-bar as indicated in the following diagram

Using the inside pin-bar to set a stop loss- Forexcentral

In the diagram, you notice the two inside pin-bars the trader has used to identify possible stop loss levels.

However during a downtrend, set the stop loss level just above the inside pin-bar as shown in the next diagram.

Setting a profit level using an inside pin bar- Forexcentral

As you anticipate, in this circumstance we use this method when shorting a trade.

Using support and resistance level to establish stop loss and take profit levels

Both the support and resistance levels are areas where there are high levels of trading activities. As a result, most traders set their take profit levels above the resistance line and their profit loss levels below the support line.

Placing stop loss below the support line- Therobusttrader

Placing the stop loss below the support line is the most widely used strategy among newbies.

For take-profit , most traders set it a few pips below the resistance line as indicated in the diagram below.

Using the resistance line to set take profit level - FBS

On the graph, the entry price is labelled 2 while the resistance line is 1. As a result, the trader sets the take profit level slightly below level 1 at 3.

Using moving averages to set stop losses

Moving averages are another reliable tool for setting stop losses since they filter much noise in the market. One of the main trading strategies is to enter long positions following crossovers between the shorter and longer period moving averages (MA). Therefore, traders can establish the stop loss levels just below the longer term moving average.

Using moving average to set stop loss- MT4tradingindicator

As you note, it is very simple to use a slow moving average to set profit loss levels.

Setting stop-losses and take profit using percentage

A trader can establish a percentage to use to set the profit target and stop loss levels. For example, the trader can use 5% less than the market price as the stop loss level and 5% more than the entry price as the take profit level. Note that this is not a fixed percentage; a trader is free to use a different one.

Using the average true range ATR

Traders can also use the average true range indicator to set the take profit and stop loss levels. Basically, the ATR indicator measures the volatility of pairs of trading assets during a period. As such, it gives an indication of the number of pips that the pair can move up or downwards.

Basically, a trader can set the take profit or profit loss level at a multiple of the ATR value. For example, the trader can multiply the value of ATR by 2. He/she can add the answer to the entry price to get the take profit level or subtract it to find the profit loss level. The following diagram illustrates the method.

Using ATR to locate the take profit level- FBS

Read more about Average True Range

Conclusion

Astute traders use stop loss and take profit levels to manage trading risks. By predetermining these levels, they remove emotions when making trading decisions. The commonest methods of setting stop loss and take profit levels include slow moving average, average true range as well as resistance and support lines.

Author: Mashell C., Gate.io Researcher

This article represents only the views of the researcher and does not constitute any investment suggestions.

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