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Stop loss orders

What is it?

A stop loss is an order that you place with your CFD provider which allows you to set a price at which you would like to exit the position should the share CFD price move against you.

A Guaranteed Stop Loss Order (GSLO) is another risk management order type that allows you to set a price that is guaranteed, regardless of whether the market trades at that price or not. This eliminates the risk of prices gapping above or below a regular stop loss order.

Case study
Given the recent share market correction, Jim sees a number of shares as good buying opportunities but is concerned about the current volatility of the market.

Stop loss orders allow you to define your risks before you open a position. Risk management is a crucial component of any trading strategy.

Jim notices that the share price of MBL has retreated from a high of $98. After finding support at $85, it started advancing again to over $90. He thinks the stock will continue to advance, and he does the following:

On 24 July 2007, Jim buys 1,000 MBL CFDs at $90 for a total exposure of $90,000.

Over the course of the next few days, MBL falls sharply, and has �gapped� down on a few occasions.

The following example illustrates the result of placing a standard stop loss order at $85 compared to a GSLO at $85.

Risk
Gapping

The Australian share market is well known for its tendency to 'gap'. This means that on the open of trade, the share price may open higher or lower than the previous day�s close without any trading occurring within the two levels.

If your stop loss is located within this 'gap area', then you will not be executed at this level but instead at the first available price level. This is referred to as slippage and tends to occur more frequently in stocks with a low daily turnover of shares or very volatile markets.

A GSLO can be used to guarantee the stop loss level, and it cannot be gapped over. However, the investor pays a premium of 0.3% to buy this guarantee. The premium is paid even if the stop loss is not triggered and represents an extra transaction cost.

Advantages of Using Stop Losses

Stop losses have a number of advantages as they allow you to:

* Close out losing positions in order to preserve capital; * Define your risk prior to entering a position.

With a GSLO the stop loss level is guaranteed.

Summary:

Stop losses should be used when trading because they allow you to define your risk before entering a trade. In fact for many trading strategies the amount you are prepared to risk determines how many CFDs will be bought/sold in the first place.

More about CMC Markets

CMC Markets is a pioneer of CFD trading in Australia. Our goal is to empower Australian traders by giving you access to CFDs over Australian and global markets and the ability to trade on leverage and potentially profit in almost any market condition. We run regular CFD introduction seminars and education courses around Australia for traders new to CFDs and are committed to providing a cost effective CFD trading service. Click here for more info or to start trading CFD's.