When it comes to risk mitigation in crypto trading, the stop loss order, or the SL, is the most effective way to control how much you allow your trades to lose in any given setup.
Far too many traders let their short-term trades become long-term investments only to end up as an outsized loss. How can we prevent this from happening and at the same time take control over how much we spend on losses each week?
One of the safest ways to invest in crypto is through a crypto exchange with stop loss where you are able to limit potential losses.
In this article, the concept of what a stop loss is and how to use it in an effective way will be described. If you are just beginning your trading journey in the cryptocurrency market or simply looking for some next-level tips, keep reading.
- Stop loss in crypto trading is an order type that is placed below or above your entry price to limit the potential for loss.
- The stop loss order is an automatic order type that will trigger a buy or sell order to close out a loss depending if your original position was a buy or short-sell order.
- Your stop loss order should be placed at such a distance that it avoids getting triggered by market noise but at the same time saves you from unexpected market turns.
You will learn
- Stop loss definition
- How a stop loss works
- How and when to use it
- Advanced techniques
- Mistakes to avoid
- Pros and cons
- Final thoughts
What is a stop loss?
A stop loss is a risk management order type that traders use to control eventual losses to manageable levels.
A stop loss order is placed at a certain distance from the entry price to protect the position from market moves that would otherwise create large drawdowns.
It can be used by all types of traders, both short-term oriented and long-term focused as a tool to block losses.
It is a tool that helps traders take control over their trading losses and make their trading systems more methodical by giving each trade a set risk profile which can then later be calculated to achieve a positive expectancy.
Importance of stop losses for traders
Without a protective stop, your trade could possibly drain your entire account leaving you bankrupt.
That is of course the worst-case scenario that it would shield you from but there are other more subtle benefits of using it.
If you want to calculate how well your day trading strategy for crypto would perform you need to know three things;
- Your expected amount to win
- Your win ratio
- Your expected amount to lose
This data is used to calculate the potential performance of your trading strategy.
Without ait, you could never calculate your risk-reward profile since your losses would be completely random.
By using the stop loss order you make things more systematic and quantifiable.
The role of stop losses in risk management strategies
The function of this order type in a risk management strategy is to make sense of losses.
Professional traders are just as focused on how much they stand to lose as they are to win.
This is the secret weapon that beginners don’t truly appreciate.
Once your risk management strategy includes both these data points you can finally create a sound strategy that will make you money.
Beginner traders tend to quickly figure out at least one or two decent setups that they can make more from.
However, they fail at keeping losses limited.
One or two big losses in a row can wipe out several weeks of positive results.
This is why the stop loss order is so useful when it comes to controlling risk.
How Stop Losses Work
A stop loss works the same way as any other order type that you use with your crypto day trading platform.
You can choose to add it before you enter the market or to an open position.
Typically, you are asked to enter it at a percentage or price distance from your entry price.
- You enter a position in Ethereum at $1522. You add your SL at $1500 to protect your downside risk.
- You enter a position in Binance Coin at $289. You place your SL at a 0.50% loss from your entry price.
Below is a screenshot from the BYDFi crypto exchange that illustrates how to add stop loss.
Before entering the position, open the SL ratio tab, and choose your stop loss price.
If you decide to add it to a position that is already open the procedure is the same but now you can take into consideration the actual market price of the cryptocurrency.
If your position is positive and you have an open profit you can choose to add the stop loss further up to lock in some gains.
However, if a position is in a loss already and you want to add the protective stop afterward, keep in mind to use the original stop price to not change your trading strategy.
Different types of stop loss orders
There are several types of stop losses that trades use in different situations.
- Hard stops
- Trailing stops
- Mental stops
The most common one is the hard stop which is the standard stop loss order type that brokers offer.
Then there is the trailing stop loss that is dynamic to the price fluctuations.
For example, if your position is a winner and the price is pushed higher, your trailing stop follows the price up at a set distance to automatically lock in profits.
This is a good strategy to use for swing trading because it lets you move up your protective stop without human interference.
A mental stop is pretty much an idea of where you would cancel out your trade at a loss and then if this price target is reached you would personally click the sell button.
A mental stop is not recommended for beginners as it can be emotionally difficult to take losses when you are first starting out.
When and How to Use Stop Losses
This part is more practical and here I will show and explain different ways you can use a stop loss to be more successful in trading.
At the end of the day, once you know how to handle and deal with your losses, that’s when you are going to shoot up on the profitability ladder.
If I had to stop this blog post right now and leave you with one tip only it would be:
Use the stop loss for every trade.
That will save you a bunch of money, however, if you want to dive deeper into the details of how to place it, the answers are written below.
When stop losses are most effective
The most effective way to use a protective stop is when you are looking at a big breakout trade.
The reason for this is that breakout trades are the most profitable trades you can ever take on a short-term basis.
Here is an example of how it can be added to a breakout trade.
Once you have identified a potentially big breakout, take a moment time to calculate the distance to your stop loss level and then select your position size.
You see, it’s the amount of risk that controls the total position size.
If you can only risk $100 and your distance to the stop loss is 100 points you need to use a pretty small position size.
However, when you find that the market is tightening up and getting smaller, your SL distance might only be 15 points but still worth $100.
This creates a much more efficient position sizing and your profitability will skyrocket once you execute these trades well.
I also want to say that these trades would be impossible to take unless your risk was fixed and pre-determined.
Tips for determining the right stop loss level
There are mainly two things to take into consideration when choosing where to place your protective stop.
- The volatility of the market
- Your total risk per trade
When you read a crypto chart you will very soon find out how volatile the price action is.
This is useful information as it will determine how wide your stop should be.
A more volatile market requires a wider stop to not get stopped out by random price movements.
A calmer market will be easier to trade most of the time as your stop can be placed closer to your entry price.
Another aspect of your stop placement is the amount of money you can risk per trade.
This will not affect exactly where your level will be but it can help you distinguish if the stop loss is too far off from your risk profile.
You don’t want to add your standard position size while trading a very volatile market.
Instead, cut your position size in half or more, and then see if it fits within your risk parameters.
How it can help traders to protect their portfolio
Most long-term investors that pick quality cryptocurrencies don’t need to worry about adding a protective stop.
When you are analyzing the fundamentals of a cryptocurrency you are looking at other parameters that most of the time don’t involve a chart.
Instead, investors should keep an eye on the driving forces of the trend such as adoption, profitability, and use cases.
However, if you are swing trading crypto and you want to be on the safe side while placing your bets, a stop loss order can help you out.
Swing traders use protective stops to avoid prices to fall below key levels such as a large support area or a huge trading range that acts as a bottom.
These times it can be wise to protect your downside if you are not planning on holding your coins for longer than a couple of weeks or months.
The fact is that many new coins that fall heavily during their first year never recover and are sent to the crypto graveyard.
Find out which the key areas in the price are and use these levels as a good target for your stop loss.
Most beginners are fine just learning how to manage their stops based on the volatility.
But when it comes to more advanced strategies, it sure pays off to know some next-level stop placements to get an edge over the market.
Below are some advanced techniques that you can use if you are trying to fine-tune your strategies and get to the next level in your trading career.
Adapting to volatility
It’s one thing to adapt to the general volatility of the market.
It’s a completely different story to adapt to changes in volatility only to get the best entry for your trade.
Let’s say that you are looking to trade Solana for a positive breakout and a possible trend trade.
Since the crypto market is highly volatile it can be difficult to get in with a large position.
At this point, your need to follow the market and enter when the volatility is at its lowest just before the market breaks out to the upside or to the downside.
Here is an example of how to use volatility when adding your stop loss.
Waiting for the volatility to drop in between breakouts will shorten the distance to our stop loss which will in turn let you trade larger while maintaining the same dollar value in your loss.
If you enter early, your stop loss distance will be too big and the same thing happens if you are too late.
There is a sweet spot a few hours before the market takes off when the market is experiencing very low volatility.
The reason for this is that most of the sellers at this level have sold and most buyers at this level have bought.
The market now has to move to the next support or resistance to find more traders and it is at this point you get in.
Follow a strict cost-per-loss strategy
It’s not enough to find a good location in the chart where to place your stop loss.
If you are not consistent with how much you spend on your losses, your trading result will not be predictable.
My first tip is to follow the 1% rule which you can read in our guide on crypto margin trading strategies.
If you follow this rule and always use add the same amount for your losses, your results will automatically improve.
It’s tough to scale down on your position size when the market is experiencing higher volatility, I know.
However, trading crypto is not about getting every trade right.
It’s about being systematic and reacting to what the market gives you.
If you are good at reading the price action of your favorite coin you will soon be able to place your stop loss based on what formation the market is doing.
Here are some examples of formations that can be useful:
- Top formations
- Bottom formations
- Continuation ranges
- Reversal formations
- Breakout formations
These can all be used to effectively place your stop loss order at a perfect distance from your entry price while still being out of reach from random market noise.
Take a look at this continuation formation that could be used as a barrier for your stop placement.
Also, within each formation, there will be signs of price breaking out or continuing that you should stay extra alert for.
These are the signals that tend to work best if you look from a probability of success point-of-view.
How Not to Use Stop Losses
Novice traders often make mistakes when first attempting to trade with a stop loss.
If you use it in the wrong way it can actually do more harm than good.
However, some simple guidance will steer you on the right course in no time.
Common mistakes traders make
There are typically two mistakes that traders make that cause them to either lose even more money than necessary.
The first mistake is to place the protective stop too close to your entry price.
This will cause the market to stop you out prematurely at the slightest market noise.
Beginner traders often feel frustrated after being stopped several times in a row which can be a costly mistake.
The other mistake is adding the stop level too far away.
While this approach might protect you from the smaller random price movements it fails because one single loss can be enough to set you back several weeks of grinding.
Dangers of using stop losses incorrectly
In both cases described above the result is always unwanted losses.
The first mistake will cause your account to bleed out from several small cuts and the other will cut a big piece of your account balance if the stop loss is triggered.
As you will learn, there is a sweet spot where the protective stop helps you avoid medium-sized losses while still keeping you in the market.
It all depends on the volatility of the coin you are trading.
The impact of emotional biases on stop loss usage
One important rule is to not change your stop level during the course of the trade.
When the position is open, leave it to its own devices, and don’t mix with the pre-determined stop loss price.
This can happen very easily due to emotions.
It is up to each and every trader to keep their emotions in check and make sure that the original plan is followed.
Emotions are after all the biggest harbinger of failure among new traders.
Pros and Cons of Stop Losses
While looking at the benefits and drawbacks of using a stop loss it comes down to each individual.
Some traders find it difficult to trade with it and others find it impossible to trade without it.
The first step is to get used to always trading with it and from there take the next step to getting good at knowing how to use it.
The most important perk of using a stop loss is the fact that you take control over your risk while trading cryptocurrencies.
Not knowing how much you stand to lose on each trade is usually what stops traders from reaching the next level.
- Risk management
- More structure
- Confidence in your setups
These are the primary benefits seen from my point of view.
Many traders will feel like they are more in charge of their trading once they learn to accept that losses are a part of the game.
The stop loss will help you in this process.
Limitations and drawbacks
Now, what are some of the negatives of using a protective stop?
As mentioned earlier, beginners tend to misuse it.
Also, simply not knowing how to place it can be a problem in itself.
- Too wide
- Too short
- Emotionally difficult
The first two negatives have already been discussed above.
The emotional difficulty tends to surface for absolute novice traders when they first learn about the stop loss.
It might seem counterproductive to stop out your position at a certain level.
Why not keep it open and see what happens?
That is usually the mindset that ends the trading career for many new traders.
The stop loss is a powerful risk management tool that helps traders limit unwanted losses automatically and adds a sense of structure to the trading strategy.
It’s a simple order type but it can help traders go from barely profitable to making a good living just by offering a strict safety net on the downside.
There are several benefits to using a stop loss.
Not only do you save your account from outsized losses, but your strategies will also improve by controlling your losses.
I recommend that all beginners use a protective stop and if you don’t know where to start you can always check our guide on regulated exchanges that offer stop losses.