No one likes to lose - most of us assume we'll win, or we'd never trade. So, many novice traders don't think hard enough about minimising losses - after all it's much more fun to imagine what you'll do with your trading gains.
However, anyone who tries spread betting should be comfortable with the phrase 'stop-loss'. And then think carefully about which type will suit them best. Here are three.
First, the plain old-fashioned stop-loss order. Say you place a buy trade on the FTSE 100 at 5,400 points, betting at £5 per point. You set a stop loss at 5,200 points. Now, the most you can lose is in theory 200 points at £5 per point, so £1,000 (since if the market falls, rather than rises, the stop loss order will kick in after a 200 point drop). But there's a catch.
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If demand to sell is heavy enough, your order may not activate at 5,200 it may activate below this level, increasing your loss above £1,000. In volatile markets in particular this is a risk. And the only way to stop it happening is to pay a little more (in the form of a wider bid-to-offer spread on the opening price) for a guaranteed stop.
The guaranteed stop does exactly what it says on the tin if you want out at 5,200 points then that's what you get. The downside is the extra cost, but this is usually worth it. And when markets are so volatile that the extra cost looks prohibitive, consider whether you should be trading at all.
Both these stop orders do, however, suffer from a flaw they activate at a particular price. And once the market starts moving up fast, a sell stop will not protect any gains you make. An alternative to lock in some gains but still get stopped out if the market falls is a trailing stop.
Take the previous example, where you placed an up bet on the FTSE 100 at 5,400 points. Let's say the stop loss is set at 5% - it will kick you out at around 5,130 points (5,400 x 0.9). Now let's say the market moves up to 5,800 points. The stop loss moves up to 5,510 (5,800 x 0.95). So now you have a guaranteed profit of 110 points (5,510-5,400) even if the market subsequently plunges.
So what's not to like? Well finding tight trailing stops can be tricky you may not get 5% for example. And again you can expect to pay a little extra compared to a plain stop. However in spread betting, where uncontrolled losses can rack up fast, peace of mind is usually worth every penny.
Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.
He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.
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