Once a trader has executed a trade that happens to become profitable, his primary goal is to keep as much of the profit as possible. The last thing anyone wants is to see profits drop, vanish or even turn into a loss.
To prevent this from happening, traders can and should adjust their stop-loss order to a level that safeguards unrealised profits, at least in part. Whether you are buying or selling short, there are various ways to employ a stop-loss order to try to protect profits.
Playing it safe: using stop-loss orders to break even
One of the most basic ways a trader can employ a stop-loss order to protect profits is to move the order to just better than the breakeven point. Traders looking to make a profit from a price rise in the market can, for instance, make use of this technique by placing their stop-loss order at just slightly above their initial buy order.
Let’s say a trader makes an initial buy at 12,000 in the DAX index, expecting it to rise to 12,050 but mindful of the fact that the market seems uneasy. They see the market subsequently advance to 12,030; at least a partial win. However, taking a conservative approach, they may move their stop-loss order to 12,005, five points above the break-even price. This enables them to protect at least a portion of their profits if the market slides back down. Whatever happens, at least they will have something to show for their efforts.
The reverse is true for traders who are selling short. Using the same example as above, let’s now imagine that the trader makes an initial entry to sell the DAX short at 11,950. They might move the stop order down to 11,995 once the market moves several points lower. Again, this enables the trader to lock in at least part of the profits. In a sense, this technique turns a hunch into a sure thing, as long as the hunch is at least initially correct.
Using moving averages to adjust a stop-loss
Once a trend gets established, it often almost seems self-sustaining. Of course, all good things do eventually come to an end, and every trend is sure to stall out or even reverse. When exactly this might happen is never certain, so it may be worthwhile protecting your profits from such an inflection.
As long as the market continues to move in a trader’s favour, they can use a stop-loss order to protect their profits by periodically adjusting its placement in accordance with the market’s most recent price movements. One popular method for determining stop-loss order placement is by placing the stop slightly below a major moving average (if a buyer) or slightly above a moving average (if selling short).
The theory behind using moving averages to help place stop-loss orders is relatively simple. When there is an uptrend in force, the price tends to stay above a major moving average such as the 10, 20, or 50-period moving average. Therefore, a trader who has recently bought some shares can continue to move their stop orders, placing them slightly below the moving average that moves up along with, but slightly trails, the spot price. This enables continually locking in a larger amount of open profit as the price advances, while ensuring a quick exit if market conditions turn sour.
Again, the opposite is true for traders selling short. The trader cashing in on a downtrend can move their stop order regularly, making sure to keep it just above a moving average line. This keeps them in the trade as long as the market moves further downward, but also acts as a safety net. If the stock should suddenly or unexpectedly become popular, they will automatically be out of the position with at least part of the profits intact.
Other technical indicators affecting stop-loss levels
While moving averages are certainly useful, there are a number of mathematical tools that can be used not just to decide when to enter and exit a trade, but also where stop-loss orders should be placed. Traders may want to use these technical indicators to adjust their stop order placement on an ongoing basis.
For example, traders can utilise the parabolic SAR. This indicator, developed by the noted technical analyst, Welles Wilder, is purposely designed to trail trends and give advance warning of potential trend reversals. (In fact, SAR is an acronym for “Stop And Reverse”.
The SAR is represented on a chart by a series of dots that always trail price movements. It is illustrated in the figure below, where one can see that a trader who had bought into the uptrend on the left-hand side of the chart would have captured a considerable portion of the advance in price before being stopped out when the price crossed the SAR dots.
A trader selling into the downtrend on the right-hand side of the chart and keeping the stop above the SAR dots would have been able to safely continue to ride the downtrend without being stopped out by temporary upside retracements, as might have been the case had they relied solely on a moving average.
The same basic theory applies when using this indicator, though. A trader looking for upward movement can continue to adjust his stop order, each time placing it slightly below the parabolic SAR dots. In the event that the market turns, the trader is stopped out before losing all of their profit. The trader selling short places his order just above the dots, thus protecting his gains and ensuring he will be protected if the market should start moving upwards.
Traders may also elect to use any of a number of other technical indicators, such as Bollinger Bands or Fibonacci retracement levels, to determine stop-loss placement.
Conclusion
Every trader wants to maximise profit while also minimising risk. Here, we have discussed three of the many ways that traders can utilise stop-loss orders to safeguard their profits in winning trades, with the assurance that they have some protection if the market turns against them. Considering that stop-loss orders are generally free to place, this seems like a very sensible precaution.
