What is a Stop Loss in Day Trading, and How To Use It

A stop loss is a type of order that gets you out of a trade at a pre-specified level. It is a way to control trading risk by telling the broker, “If the asset reaches X price, get me out.”

Stop losses are imperative for day traders because prices move quickly – having a stop loss assures you get out of the trade if a pre-specified level is reached. You don’t have to rely on your memory or reflexes, which may get you out of the trade later than an automated order.

Learning how to use stop loss orders is an important skill to have, because controlling risk is an important skill for successful trading. Today, we will cover what a stop loss is, the different types of stop losses, how to place a stop loss, and where to put a stop loss when entering a trade.

What is a Stop Loss in Day Trading

A stop loss order is an order that closes a trade if the price starts moving against the direction of the position. The order type is actually a “stop order”, but it is referred to as a stop loss in this context.

A sell stop order will sell below the current price. If you purchase a stock or other asset, then your stop loss is a sell stop, because it will sell at a lower price than where you entered.

A buy stop order will buy above the current price. If you short sell a stock or forex pair, then your stop loss will be a buy stop because it buys (to close your position) above where you entered.

The stop loss strategy controls the risk on the trade in the event the price doesn’t go in the direction you expect. For example, let’s say you buy a stock at $50.25 expecting it will rise. You set a stop loss (sell stop) at $49.99 just in case it doesn’t. This way, you limit your risk to $0.26 per share.

If you shorted the EUR/USD at 1.1525, and placed a stop loss (buy stop) at 1.1535, the order will get you once the price has moved 10 pips against you. With many brokers, placing an entry order will also give you the option to place a stop loss. In this case, simply enter the stop loss price you want to use. You don’t need to select the order type (sell stop or buy stop).

Different Types of Stop Losses

There are several types of stop losses, but the main ones are market, limit, psychological, and physical. In nearly all cases you will be using a market-physical stop loss, but it’s worth understanding the other types as well.

The most common type of stop loss order has two key features:

• Market – meaning the stop loss is a market order. When the stop loss is reached the order is sent out and will use the current market rate to exit the position.
• Physical – meaning the order has been physically placed and the stop loss order is pending with the broker, ready to be deployed if the stop loss price is reached.

If you are placing the order, it is physical, and by default, stop loss orders are market orders. While these are the most common types of stop losses used among professional day traders, there are a couple of other choices.

• Stop Limit – a stop limit will only get you out of a trade within a pre-specified price area.
• Mental – a mental stop loss means you don’t actually place a stop loss order. Rather, you mentally decide where you will exit, and then if the price reaches that level you manually exit the trade.

If you opt to use a mental stop loss, that means if you have bought something, you just have to sell it to close the position. If you are short, you have to buy the same amount to close the position. A stop limit adds a “limit” to the stop order. For example, if you buy a stock at 25.60, you could place a stop limit order at 25.50 (stop) and 25.40 (limit).

This means if the stock price reaches 25.50, the order is deployed and it would try to sell your position at whatever the current market rate is. However, it would only sell your position if it can get you out at 25.40 or higher. In this scenario, it would only get out between 25.50 and 25.40, and no lower.

If the price were to “gap” from 25.50, and the next person willing to buy is at 25.39, you would still be in this position until someone is willing to buy at 25.40 or higher. At that point, your order to sell would be executed. If the price keeps dropping, without the order executing, you are still in the trade and the loss is getting bigger.

There is almost no need to use a stop limit order as a stop loss when day trading; simply get out of the trade using the default market order and move onto the next trade.

How to Place a Day Trading Stop Loss

In order to manage risk, the stop loss needs to be physically placed. As discussed above, just thinking about where you should get out isn’t good enough. One lapse in attention could mean a significant loss.

Let’s discuss how to place a stop loss, so you always know your risk is controlled.

Most brokers allow you to place a stop loss when placing an entry order. If you are given this option, when placing a trade entry price, input the price of the stop loss. When you send the entry order, the stop loss is attached to it and will get you out if the price reaches the stop loss level. The stop loss order only comes into effect once you are in a trade.

If the broker doesn’t offer you a stop loss option when making a trade, you can input it manually using the order types discussed above. If you are buying, enter the trade and then input a sell stop order at the price you want to get out of the trade. If you are shorting, enter the trade and then input a buy stop order to get out of the trade if the price goes against you.

If you are in a trade and don’t have time to place a stop loss, you can always close a trade manually by selecting the “Close” option. Most brokers offer this. You might be able to right-click on the trade to access this option, or there may be an “x” you click beside the trade to close it. This is a manual exit option, so it is like a mental stop loss.

Where to Place a Stop Loss Order

When you enter a trade, you need to decide at what price level to place the stop loss. The general idea is to place the stop loss at a price that would indicate you were wrong about the trade – at least for now.

Many day traders use recent swing highs and lows for stop loss locations, or reference recent candle highs and lows. Here is a chart example: