What Are Stop-Loss and Stop-Limit Orders?
Let’s be real; the only reason you’re trading is to make profits. However, losses are inevitable, especially if you’re trading in a volatile market.
But what if there’s a way to mitigate these risks?
I bet you’re guessing a stop-loss order, and you’re right. In fact, it’s one of the most common risk management techniques to limit potential losses. Still, what is a stop-loss?
Well, this is generally an order type used by traders to trigger the exit of a position when the price goes against them until touching a predefined level. When the price crosses that level, the position is closed automatically by the trading platform to avoid further losses.
What Is A Stop-loss Order?
A stop-loss order is a universal risk management technique applicable in stocks or even crypto trading to effectively limit potential losses. But giving traders the flexibility to trade with confidence. In most cases, traders use this order type to set a specific price level at which an existing order would automatically close if the price touches it.
The best part? It’s all automated.
Technically, stop-loss is a conditional instruction that a trader gives to the cryptocurrency exchange. When a cryptocurrency price touches the predefined level, the order automatically converts into a market order, which executes at the next available price. The stop-loss can be set at any price level and can instruct the crypto exchange to buy or sell the cryptocurrency, depending on the nature of the existing position.
To give you an example, check the chart below:
As you can see, we have a so-called ‘Shooting Star’ candlestick pattern, which generally shows up at the top of an uptrend and anticipates a bearish reversal.
Let’s say you decided to open a short position and want to place a Sell Order on Bitcoin. However, we are unsure whether the price will move according to your expectations – no trading pattern can guarantee us that the price will move in one direction or another. Thus, we set a stop-loss order right above the Shooting Star candle if the price continues the bullish move.
Supposedly that happens, the stop order is triggered, and we end up with a loss. However, at least we know that the loss is limited, which helps us control the situation. Fortunately, the price shown in the example above continued to decline as planned, and the stop-loss wasn’t triggered at all.
Ultimately, stop-loss orders are here to help you save time, along with the take profit order. While the latter triggers the exit of a profitable position.
Let’s say you use these orders; you’ll steer away from the exhausting practice to regularly monitor your positions. Stop orders are ideal for short-term traders who need to automate most of their trading process. If you are a swing trader who keeps a few positions open for weeks, you may not even need the stop-loss that much as soon as you check the prices daily. Still, using the stop-loss is super easy, and you lose nothing setting them.
Sell Stop Orders
So you’re confused? Don’t!
The rationale behind this approach is pretty simple. You need to know that the sell stop order is used to protect long positions in bullish markets if an unexpected bearish reversal occurs. That means the order will automatically trigger a sell order if the price drops below a certain level decided by the trader.
So, if the price declines thus far, it may continue to drop even further. Hence, the trader would prefer to cap the losses, and the sell stop order is used to automate the risk management process.
For example, let’s say a momentum trader identified a bullish trend that may continue its path. As you can see in the sample above, he entered a long position when the bullish candle broke above the local resistance. He then chooses to set a sell stop-loss right below the previous local support level to protect his position. So even if the price suddenly plunges and touches the stop-loss level, he’ll end up with a limited loss.
Buy Stop Orders
The buy stop order is just the opposite of the sell stop order. We use it to protect our short positions. In fact, the stop order from our first example is nothing else than a buy stop order. It automatically triggers an exit by closing a short position when the price ascends.
Can You Use Stop-loss Order in Crypto Trading?
Of course, it can!
In fact, not only can you use the stop-loss order in cryptocurrency trading, but you must oblige to consider it if you want to succeed in your trading journey.
Stop-loss orders are especially relevant for crypto traders, given that cryptocurrencies are incredibly volatile and the market hasn’t matured yet. Imagine the price of Bitcoin goes side-ways, defying technical analysis logic, you’ll see your hard-earned balance wiped out within minutes.
So, to stay on a safer path, a stop-loss order is the way to go. Besides, it’s a must-have feature for most crypto exchanges, so there is absolutely no excuse not to use it, especially if you are a day trader.
How to Use A Stop-loss Order Correctly?
The main goal of a stop-loss is to limit potential losses. However, simply placing a sell stop-loss order below the market price might not necessarily protect your long positions, and vice versa.
In order to get the maximum effect, you have to learn to use the stop-loss order correctly.
So where should I place it?
And here’s how:
It depends on the situation. Still, as a rule, you would be interested in setting the stop-loss near the previous support or resistance levels. For example, you should place the sell stop-loss right below the previous support level, whether it’s an uptrend or a horizontal channel.
In our example of the sell stop-loss order, we placed the order near the previous reliable support. You can identify the support of a trend by checking where the price is bouncing back after touching an imaginary line.
However, if you use specific strategies or rely on chart patterns, which we recommend you to do, you should have precise rules on placing the stop-loss order. For example, if you trade the Head and Shoulders pattern, the buy stop-loss is calculated from a distance between the pattern’s neckline and its peak.
What Is A Stop-limit Order?
A stop-limit order is a more complex order that helps traders protect their positions. The stop-limit order merges a stop order with a limit order. When the cryptocurrency touches the stop price set by the trader, it automatically triggers a limit order. Next, the limit order is executed at the set limit price or better.
Still don’t understand how stop-limit order works?
Well, first of all, you should know what a limit order is. Unlike the market order, which executes the instruction immediately, the limit order executes when the cryptocurrency touches a certain level set by the trader.
So the stop-limit order has two orders, and you should set two prices:
- The stop price – at this level, the price will trigger the limit order, which will execute only if the price touches the limit price set by the trader. Otherwise, the order will never execute.
- The limit price – this is the second price that the trader should set for the stop-limit order. After the stop price triggers the limit order, the limit price will only execute if the cryptocurrency touches it.
In other words, the stop-limit order is a risk management tool that gives traders more control over the price at which the order should execute. This order may work in volatile markets, so it’s very relevant for cryptocurrency traders.
Why would you need a stop-limit order when there is the stop-loss anyways?
Well, stop-loss orders cannot protect your positions if the price goes against you and forms gaps or flash crashes or even regular crashes that happen here and there during volatile markets.
For example, if you set the stop-loss for an up-trend Bitcoin at $30,000, the price can suddenly drop to $29,900, and your stop-loss will work at this price instead, which means that you lose $100 more than you had planned.
Alternatively, suppose you use a stop-limit order with the trigger price at $30,050 and the limit price at $30,000. In that case, the order will get triggered when Bitcoin drops to $30,050, and the position will get automatically closed only if it touches $30,000.
For example, if it suddenly drops to $29,900, it won’t execute. The order will be pending until the Bitcoin price potentially rebounds to $30,000, at which point the order will execute.
How Should You Use A Stop-limit Order?
You should always use a stop-limit order. But it’s even better if you use it when the market is volatile and want to control your profits and losses.
For example, check the chart below:
Let’s say that you decided to short Bitcoin when the red candle broke below the previous support (1). You set a buy stop-limit order that will have a stop price and a limit price.
In our example, the price suddenly bounces back and takes you by surprise. It touches the stop price (2), which triggers the limit order. However, the order doesn’t execute until the limit price is touched, and there is a seller at the other end that offers the exact price you need (3).
But let’s say that the scenario in the 3rd point didn’t work. Suppose the price is volatile and suddenly crosses the limit price without executing because there was no seller on the other side (and thus, the price condition couldn’t be fulfilled). In that case, the order will not execute and will stay open until Bitcoin doesn’t touch the specific price set by the trader in the limit order.
In our example, Bitcoin comes back and crosses the limit price again (4). At this time, there is an available price at which the order is executed, and the short position is closed. Basically, the stop-limit order lets you hang on and wait for the price to pull back.
Stop vs. Stop-limit Orders
The stop-loss and stop-limit orders are similar because their goal is to protect the open positions.
However, the difference between the two shows up when the price hits the stop. In the case of the stop-loss order, when that happens, the position closes automatically. The bad news is that the position might not necessarily close at a price specified in the stop-loss order, which may happen during flash crashes or gaps.
So, in the case of the stop-limit order, when the price touches the stop, it only triggers the limit order that executes only if the price touches the limit price.
The stop-limit order gives traders more control over their positions regarding the prices that trigger a market exit. However, stop-losses are easier to use and can limit losses.
Benefits and Risks of Stop-Loss and Stop-Limit Orders
They’re both here to help you manage your positions more efficiently. But did you know they can help you automate the trading process too?
In fact, it’s useful to help you focus on other tasks while analyzing the market for trading opportunities.
However, the downside is even if you use any of these two orders, it doesn’t mean you are 100% protected from major losses.
A stop-loss may not work perfectly well during flash crashes and price gaps, leaving you with bigger losses than expected. On the contrary, the stop-limit order may not execute at all if the price doesn’t touch the limit price. Hence, it would be best if you keep an eye on it even though it’s automated.
The Bottom Line
As a recap, stop-losses and stop-limit orders are great methods to minimize losses in case the price goes against you. As the wise words say, ‘practice makes perfect,’ and trading is no exception. Hence, you should try and make as many errors on your demo account before dive right into it. Make sure you understand how they work and pick one of them as the primary risk management technique.
*This article is intended for and only to be used for reference purposes only. No such information provided through Bybit constitutes advice or a recommendation that any investment or trading strategy is suitable for any specific person. These forecasts are based on industry trends, circumstances involving clients, and other factors, and they involve risks, variables, and uncertainties. There is no guarantee presented or implied as to the accuracy of specific forecasts, projections, or predictive statements contained herein. Users of this article agree that Bybit does not take responsibility for any of your investment decisions. Please seek professional advice before trading.