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Stop-loss and take-profit levels are essential risk management strategies that should be considered, especially in your short-term trading plans.
A stop-loss is an order you place to your trades to exit a position if the market moves against your plan.
A take-profit is a standing order you place to exit a profitable trade once an asset price hits a specified price level.
You can use support and resistance levels, moving averages, and market sentiments to place a stop-loss or take-profit order.
Establishing stop-loss and take-profit levels in crypto trading is integral for risk management, especially considering the volatile nature of this space. It’s advisable to always consider these risk management strategies, especially in all your short-term investment positions. Entering positions without these strategies is risky as your positions may negatively or positively continue with their trends.
If you apply it appropriately, a stop-loss will help you to avoid losing a large portion of your investment, while a take-profit helps you safeguard your gains and exit the position positively. Once set, these two strategies execute automatically at the pre-set levels.
This article discusses stop-loss and take-profit, types of stop-losses, why stop-loss and take-profit levels are essential, and how to set a stop-loss and take-profit.
What is a Stop-Loss?
A stop-loss is an order you place to your trades to exit a position if the market moves against your plan. As the name implies, a stop-loss is meant to limit your downside by exiting a position if the market moves against your trading plan.
For instance, if you create a long position, you plan that the price will increase. But if the asset’s price drops, you will accrue losses on your investment. If these losses persist unmonitored, your investment may be significantly affected. Placing a stop-loss order helps you to automatically close a position when the accumulated losses reach a certain level.
When setting your stop-loss, consider the existing market conditions and period you plan to keep your investment. Technical indicators that evaluate market conditions, such as support and resistance levels, moving averages, and market sentiments, are helpful here. Besides, you can set your stop-loss subjectively based on your risk appetite.
You set your stop-loss above the selling price for a short position since you expect the price to decline. If the market assumes an uptrend, it implies your investment is at risk because you’ve guessed wrong, opening you up to the possibility of losing your entire investment. Therefore, setting a stop-loss will help you to control your losses.
You set the stop-loss below your entry for a long position since you expect the price to rise. If the market assumes a downtrend, it means your portfolio is at risk. As such, setting a stop-loss ensures your position is closed at a specified point, preventing you from incurring further losses.
The Importance of a Stop-Loss in Crypto Trading
A stop-loss is essential, whether you are longing or shorting the market. Let’s see some of the benefits of setting a stop-loss.
The first benefit of a stop-loss is to limit your losses. When you set the stop-loss appropriately, if the market trends against your trading plan, you will only lose what you are willing to lose since you are the one who set the level. It also ensures you lose what you can afford to lose, mainly when trading with leverage, like in margin trading. Generally, a stop-loss prevents one poorly executed trade from significantly affecting your portfolio.
For example, assuming you own 1 BTC and set your stop-loss at 5%. If the market goes against your projection, you will only incur a loss of 5%. But if you haven’t set a stop-loss level, you may lose a significant portion of your portfolio.
Preventing Premature Exits
Whether you are a newbie or a seasoned trader, you aren’t immune to emotional impulses when trading cryptocurrencies – more so during a crash, correction, or bear market. Setting a stop-loss prevents you from making emotional decisions that may adversely affect your position. Without a stop-loss level, fear may control you to exit your trade prematurely. On the other hand, you may also overstay in a losing streak, hoping the market will reverse soon. A stop-loss will ensure you conform to your trading strategy.
For instance, assume you have Done Your Own Research (DYOR) and bought BTC, but you failed to place a stop-loss order. If the BTC price trend goes against your plan, you may still be convinced that your research is perfect and that the trend will follow your plan soon. As such, you may be tempted to remain open even if bitcoin doesn’t seem to reverse, which may significantly impact your portfolio.
Types of Stop-Losses
You can apply several types of stop-losses in different market conditions. They include Sell Stop-Loss, Stop-Limit, and Trailing Stop-Loss. Let’s discuss each of them in detail.
Sell Stop Order
A Sell Stop-Loss is also known as a Stop Market Order. You can use it to sell a coin at market price when it hits a certain price level (the stop price). The order is implemented when the level is attained, and the coin is sold at the next available market price, which could make a difference in the actual loss incurred than if your entire position was completely closed at the exact price as your stop market order.
A Stop-Limit Order resembles a sell stop order – they only differ in execution. Instead of selling the asset at the market price once the stop price is hit, a stop-limit order places a limit-sell. This implies that an order will be completed if the pre-set price limit order level is hit.
Most traders prefer sell stop orders to stop-limit orders because the latter requires the limit price to be met. During market crashes, limit sell orders mostly remain uncompleted, leaving investors holding unto positions in unpredictable downtrends. On the other hand, a sell stop order ensures the order is filled at the best available market price.
Trailing Stop Orders
A Trailing Stop Order is a modern type of stop-loss that places a fixed percentage below the market price and keeps correcting upwards. For instance, if you enter a BTC long trade at $200 with a trailing stop-loss of 10%, your stop level is at $180. If the price rises by 20% to $240, the stop-loss trails it and adjusts to $216.
If the asset price starts declining, the stop-loss will remain unchanged, and the position will be filled at a market price of $216. Trend traders often use trailing stop orders to keep their trades open for extended periods without changing their stop levels regularly.
What is a Take-Profit Order?
A take-profit is a standing order you place to exit a profitable trade once an asset price hits a specified price level. As the name suggests, a take-profit allows you to set a predetermined level to withdraw your gains, letting you take the profit by exiting the trade.
Suppose you long BTC at $17,000, anticipating its price to appreciate. Since you want to exploit the situation, you set a take-profit order at a point higher than your entry price, say $17,500. If the price of BTC reaches $17,500, the order will be filled and your profits will be locked in.
Likewise, you can short BTC at $17,500, anticipating the price to drop. Here, you analyze the market and estimate the bottom of where to enter the market. Assuming you enter the market at $17,500 and expect the price of BTC to drop to at least $17,000, you may set your take-profit orders at that specific level.. Your order will be triggered once the price reaches $17,000, and you will have benefited from the price plunge.
The Importance of a Take-Profit Order
There are multiple benefits of a take-profit order:
Ideal for Securing Quick Gains
A take-profit order is ideal for investors focusing on short-term gains. If the price of an asset appreciates as projected, a take-profit order will help you to secure your profits by exiting the market when the trigger price is reached.
Minimizes Emotional Trading
As an investor, you might grow a personal interest in the success of an investment. This can stress you and even make you start second-guessing. By placing a take-profit order, you can proceed with other activities stress-free since you have already committed to the exit level and cashed out the profit, if it hits your desired price target.
How to Set Stop-Loss and Take-Profit Levels
You can use multiple methods to establish the best stop-loss and take-profit levels. You might apply these methods independently or in combination, but they all have a mutual objective – to utilize the available data to make more informed investment decisions. They include:
Support and Resistance Levels
An asset’s support and resistance levels are primary elements of technical analysis in the stock and cryptocurrency markets. These are zones in a price chart that are more likely to have high trading activity – either bids or asks. You should expect downtrends to stop at a support level because of a high number of ask orders (buy requests). On the other hand, you should expect the uptrend to stop at a resistance level because of a high number of bids (sell requests).
When using support and resistance levels to set stop-loss and take-profit levels for long positions, you should place your take-profit order below or at the next resistance zone, while stop-losses should be placed below the resistance zone you have identified.
Moving averages (MAs) help you sieve market noise and smooth price action data to establish a market trend. You can calculate the MAs based on your preference – over a short or long-term period. You should monitor MAs closely to find opportunities to short or long, as illustrated by crossover indicators – two different MAs (say a 50-Day MA and a 200-Day MA) cross on a chart. Often, you will spot a stop-loss below a long-term MA.
Instead of a predetermined level based on technical indicators, you can utilize a fixed percentage to set a stop-loss and take-profit level. For example, you can place your stop-loss or take-profit once a token’s price is 8% below or above your entry price. Moreover, the percentage method is the easiest, which is ideal for investors who are less familiar with technical analysis.
You can establish the stop-loss and take-profit levels based on the market sentiments. For example, you can place a stop-loss on your portfolio following a major crypto event, like the recent FTX collapse.
Conclusion: Stop-Loss vs. Take-Profit
Stop-loss and take-profit are two essential risk management strategies you should consider, especially in your short-term trading plans. The difference between them lies in their objectives. A stop-loss is designed to cap the loss you can incur from a trading position. The trigger price is always lower than your entry price if you’re in a long position and it is higher than your entry in a short position. On the other hand, a take-profit order is meant to capitalize on short-term profits on open trades. If you have a long position on an asset, the trigger price usually is higher than the entry price, meaning you will exit the market at a profit. Though these strategies have different objectives, they work perfectly together.