What Is a Stop Loss and Take Profit?

Stop loss and take profit orders are important risk management tools for traders to be aware of. Whilst it might be beneficial to use both as part of your trading strategy, there are also potential disadvantages to bear in mind.  

In this article, we will explore both in detail, highlight the main pros and cons and demonstrate how to set stop loss and take profit orders.

The information in this article is provided for educational purposes only and does not constitute financial advice. Consult a financial advisor before making investment decisions.

Key Takeaways

• Stop loss orders can be used to automatically close a losing trade when the market moves against you. 
• Take profit orders automatically close a winning trade in an attempt to secure potential gains. 
• Stop losses, in particular, can be an important risk management tool. 
• Both tools can help reduce emotional decision making and allow traders to predefine an acceptable risk and reward for each trade. 

What Is a Stop Loss in Trading?

A stop loss is an order to automatically close an open position if the market moves in an unfavourable direction and the price hits a predetermined level.

It is an important risk management tool, used by traders and investors to try to limit potential losses in the financial markets. 

Stop Loss vs Stop Limit

A stop-limit order is similar to a stop loss; but there is an important difference. 

With a stop loss order, once price reaches the predetermined level, the stop loss will execute as quickly as possible at the next available market price. 

Consequently, depending on market conditions, the price at which the order is executed might be higher or lower than what was specified in the initial stop loss instruction. 

On the other hand, a stop-limit order will only execute at the predetermined price or at a price which is more favourable for the trader. If it can’t execute at the limit price and the market continues to move in an unfavourable direction, the order won’t be filled.

What Is a Take Profit in Trading?

Like a stop loss, a take profit order is used to automatically exit an open position once price reaches a predetermined price.  

However, whereas a stop loss is designed to limit potential losses, a take profit is used to try and lock in potential profits. As with a stop loss, once the predetermined price is reached, the take profit will execute at the next available price, which might be different to what was originally specified. 

In other words, if the market moves against the trader and reaches the stop loss level, the position is automatically closed for a loss; if the market moves in the desired direction and hits the take profit level, the position is closed for a potential gain.

Why Use Them?

By using stop loss and take profit orders, traders can predefine and lock in an acceptable risk to reward ratio for each trade.  

Below, we’ve highlighted the main advantages and disadvantages of using stop loss and take profit orders.  

Advantages

• Automated Risk Management: A stop loss order is an important risk management tool, which can try to help limit downside when the market moves against you. 
• Removes Emotion: Predefining and locking in a trade’s risk to reward can help with discipline, reducing the possibility that emotions such as fear or greed will interfere with your objectives. 
• Saves Time: Stop loss and take profit orders can reduce the need for traders to constantly monitor their positions. 
• Locks in Potential Gains: A take profit can automatically attempt to lock in potential profits once the target is reached. 

Disadvantages

• Slippage and Price Gaps: Stop losses execute at the next available price. In a fast moving or illiquid market, this may result in execution occurring at a worse price than specified in the original stop loss order. 
• Premature Exit: If a stop loss is set too close to the entry price, it could get triggered on normal market volatility, potentially cutting a good trade short. 
• Opportunity Cost: A take profit order is executed once price reaches the target level even if the security’s price continues moving in the desired direction. 
• Short-Term vs Long-Term: Take profits in particular might not be as suitable for longer-term traders and investors who want to let potential profits run over a longer time frame.

Where to Set Stop Loss and Take Profit Orders

Amongst other things, the answer to this will depend on the trader in question as well as which market they're trading.

Some traders may have a specific percentage which they are willing to risk on each trade and choose to set their stop loss levels accordingly. Similarly, with take profits, a trader might have a predefined risk-to-reward ratio which will help their placement. 

However, using the same distance for stop loss placement may not be appropriate for every asset.

For example, in volatile markets, traders may choose to place stop levels slightly further away from their entry, to prevent their position stopping out prematurely due to normal fluctuations within the market.

It’s also common for traders to use technical analysis tools – such as support and resistance levels - to help decide where to place stop loss and take profit orders.

For instance, when entering a long (buy) position, a trader might place a stop-loss just below a nearby area of historic support, where price has previously bounced upwards. Similarly, the same trader may target a profit just below an area of historic resistance, where rising prices have previously stalled.

How to Set a Stop Loss and Take Profit

The exact process for setting stop losses and take profits may vary depending on which trading platform you use.

However, you will generally find options for setting stop loss and take profit levels in the order entry window when placing a trade. Here, you can specify the levels at which you wish to place them.

The image below highlights exactly where you can enter stop loss and take profit levels when trading using the Admirals Platform. 

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