Why you should mind the gap when using stops
If you’re an experienced trader familiar with spread betting and CFDs, you’re probably familiar with stop-loss and limit orders. These tools are useful for limiting losses and protecting profits, but they aren’t infallible.
What are stop-loss and limit orders?
To recap: a stop-loss order allows you to close a position automatically when it hits a certain price, thus preventing you from suffering further losses.
Limit orders also allow you to close a trade when it hits a certain level, but this time they are used to secure a profit.
You can also add trailing stops to your positions, which move up or down in lockstep with the market, so your stop level adjusts automatically when the market is moving in a favourable direction.
You can adjust and cancel your stop and limit levels on open positions as long as you have sufficient funds to cover any increased margin requirement.
How are stop-loss orders subject to gapping and slippage?
Financial markets can be volatile. Changes are not always methodical, moving point-by-point at a moderate pace. Sometimes, massive gains or drops will occur within seconds, often in response to unexpected company news or global events.
Gapping occurs when a market (commonly at opening but also sometimes intraday) moves from one price to another without moving through the prices in between, bypassing your stop-loss position.
For example, if you placed a stop-loss order on a long position at £100, and the price drops from £105 to £95 overnight, your stop-loss can only be executed at £95.
Your stop-loss can also be affected by slippage. This occurs during the trading day in periods of high volatility, when the market is moving so fast that your stop-loss order, once triggered, cannot be executed at the exact price you desire. Your position will instead be ‘stopped out’ at the best available price.
All brokers offering leveraged products within the European Union are required by EU law to provide clients with negative balance protection ensuring clients do not lose more than the balance on their account. Note this applies to retail clients only, not those with professional classification.
Don’t get stopped out too early
Using stop-loss orders too liberally can reduce your chance to make a profit. Setting your stop level too close to your entry level is a common mistake that traders – even experienced traders – make. Markets need time to move. If you set your stop too close, you will need the market to move the right way immediately. It cannot drop and rebound in your favour if you are overly cautious and place a stop that ends the trade quickly.
Remember to give your position some breathing room. Stop-loss orders should be used to prevent large losses, but should never be viewed as a way to stop all losses.
On the other hand, if you set your stop-loss too wide you can lose a substantial part of your trading account on a single trade. The exact placement of your stops is an essential skill for the successful trader.
You should under no circumstances consider the information and comments provided as an offer or solicitation to invest. This is not investment advice. The information provided is believed to be accurate at the date the information is produced.