Stop-Loss and Take-Profit: How They Work and How to Use Them Properly

Stop Loss and Take Profit have become essential when trading on any type of market. These tools help to close the profit or loss in a deal in time and at the right prices, thus limiting the risks and saving the trading deposit. 

Stop-Loss - what it is and how it works

Stop-Loss is a tool designed to limit losses on financial markets. It represents a price level, after reaching which a deal is automatically closed to avoid further losses.

The principle of operation of Stop-Loss is based on the trader setting a certain price threshold below (for buying) or above (for selling) the market price. When the asset price reaches this level, the program will automatically close the position, minimizing losses.

Take-Profit - what it is and how it works

Take-Profit is a type of pending order that fixes profit in a deal automatically after reaching a specified price level.

Take-Profit works similarly to stop-loss, but in the opposite direction: when the price reaches the selected profit value, the position is closed without the need for trader's intervention.

How to set stop-loss and take-profit correctly

The correct positioning of stop loss and take profit requires careful market analysis and understanding of technical analysis levels. Key recommendations:

1. stop loss (SL) setting technique:

1.1 Basic principles of setting a stop loss

• Stop-loss must be logically justified - you cannot set it arbitrarily.

• It should take into account volatility - on more volatile assets the stop-loss should be wider.

• It should not be too close to the entry price - otherwise it will often be knocked out by market noise.

• It should correspond to risk management - do not risk more than 1-2% of the deposit in one trade.

• It is calculated before entering a trade - do not move stop-loss in the direction of increasing losses after entry.

1.2 Ways to set a stop-loss

According to technical analysis (key levels)

• Behind the support/resistance level - it is placed behind an important level, as a breakdown of the level may mean a change of trend.

• Behind candlestick highs/minimums - if the stop loss is placed behind a local peak, a breakout of the position indicates a possible continuation of the movement.

By volatility

Using indicators such as:

• ATR (Average True Range) - stop loss is placed 1.5-2 times the value of ATR.

• Bollinger Bands - stop-loss is placed outside the Bollinger Bands.

By time

• If the price does not move in the desired direction within a certain time, you can close the trade manually.

Fixed percentage or monetary value

• For example, 1-2% of equity or 50 pips for currency pairs.

Trailing Stop

• Dynamically moves the Stop Loss to follow the price and lock in profits.

1.3 Mistakes when placing a Stop Loss

• Stop Loss is too close → will be knocked out by random fluctuations.

• Stop loss is too far away → large losses.

• Moving the stop loss in the direction of increasing losses → lack of discipline.

2. How to set take profit (TP) correctly:

2.1 Basic principles of take profit setting

• Take Profit should be realistic - price should have a chance to reach it.

• Must take into account the volatility of the asset - the higher the volatility, the farther the TP.

• It should provide a positive risk/profit ratio (at least 1:2, and better 1:3).

2.2 Ways of setting Take Profit

By support and resistance levels

• TP is placed before strong levels where reversal is possible.

By Risk/Reward Ratio.

• For example, if SL = 10 pips, then TP = 30 pips (1:3 ratio).

By technical figures and patterns

• If there is a “Head and Shoulders” pattern, then TP = height of the head.

By volatility

• Using ATR, Bollinger or average price movements for the day.

Partial exit from the deal

• You can lock in half of the profit at the first level and leave the rest with a trailing stop.

Using trailing profit

• Gradual fixation of profit, moves following the price.

2.3 Mistakes when setting Take Profit

• TP is too close → short profit.

• TP is too far away → price may not reach it and turn around.

• Ignoring market factors → it is important to adapt to the situation and be in context.

3. Example of setting stop loss and take profit:

Example 1: Trading on support and resistance levels

• BTC/USD price = 50,000

• Support at 49,500, resistance at 51,000.

• Buy entry: 50,000

• Stop Loss - below support, e.g. 49,400

• Take Profit - just below resistance, e.g. 50,900.

• Risk/profit ratio = 600 (TP) / 300 (SL) = 1:2

Calculation of levels for stop-loss or take-profit setting

The main methods of calculation:

1. Fixed distance - stop loss is placed a certain number of points from the entry point.

2. ATR (Average True Range) method - based on the average volatility of the asset.

3. Support and resistance levels - stop loss is set outside the key levels where the price can turn around.

4. Fibonacci levels - using Fibonacci levels to identify potential reversal points.

Pros and Cons of Stop Loss and Take Profit

Pros of stop loss:

1. loss limitation

• The main advantage of a stop loss is that it allows you to reduce losses in case of price movement in the opposite direction.

• It automatically closes an unprofitable position without the need for constant monitoring.

2. Psychological comfort

• Takes the emotional component out of trading, preventing panic and impulsive decisions.

• Allows traders to stick to a predetermined strategy.

3. risk management automation

• Allows to calculate risk and potential profitability in advance before opening a trade.

• Especially useful when trading volatile markets.

4. Protection from sharp market movements

• In case of unexpected market reversal (for example, on news) helps to avoid large losses.

5. Suitable for all types of trading

• Used by both short-term and long-term traders.

• Effective in scalping as well as in medium or long term trading.

Minuses of stop loss:

1. false positives due to market noise

• In volatile markets, the price may break the stop loss level for a short period of time and then continue moving in the desired direction.

• This leads to premature exit from the position.

2. Slippage risk

• In conditions of low liquidity or sharp price movements (for example, during the release of important news), the stop-loss may be executed at a price worse than the set level.

3. limiting potential profits

• If a stop is set too close, it can often knock a trader out of a trade, preventing the price from reversing and generating profits.

4. Does not take into account changes in market conditions

• A fixed stop may not adapt to changing volatility.

• A solution may be to use a trailing stop (dynamically changing stop loss).

5. Can provoke a series of losses

• If a trader frequently blows out a stop, he may start to change his strategy or refuse to use it at all, which can lead to uncontrollable losses.

The advantages of take profit:

1. Guaranteed profit taking

• Profit fixation at a predetermined level without trader's participation.

• It is useful in situations when the market quickly reverses after reaching the target level.

2. trading strategy automation

• Allows you to set closing levels in advance to help you follow your trading plan.

3. Protection from psychological influence

• Avoids the temptation to “sit out” profitable trades in the hope of even greater growth, which can lead to loss of profit.

4. Suitable for short-term trading

• Intraday and scalping strategies require quick closing of positions, and Take Profit is ideal for this.

5. Provides stability

• Even if the market changes direction, Take Profit helps to lock in profits, preventing them from turning into losses.

The cons of take profit:

1. profit limitation

• If the trend continues in the desired direction and the take profit has already been triggered, the trader may miss out on additional profit.

• For example, the price continues to rise after the takeout is triggered, but the trader is already out of the market.

2. Risk of failing to reach the target

• If the takeout is set too far away, the price may not reach it, turn around and go to a loss.

3. lack of flexibility

• Unlike a trailing stop, take profit does not adapt to changing market conditions.

4. Can reduce the effectiveness of long-term investing

• In long-term trading, it is better to use a trailing stop to allow profits to grow rather than locking them in at a predetermined level.

5. Can cause psychological addiction

• Traders may get used to placing take profit too close for fear of missing out on profits, leading to premature closing of positions and reduced returns.

Common mistakes and how to avoid them

1. Mistakes when setting a stop loss

1.1 Setting a stop loss too close to the entry point 

Many traders set a stop too close to the entry point, hoping to minimize losses. However, even small market fluctuations can knock out the position, after which the price will go in the desired direction.

How to avoid:

• Take into account the volatility of the asset. Use the ATR indicator to calculate a reasonable stop loss.

• Place the stop behind significant support and resistance levels.

• Check how often the asset makes false breakdowns and leave a margin.

1.2 Setting a stop loss too far away

Some traders set a stop loss too far away in an attempt to sit out a drawdown. As a result, they end up taking large losses.

How to avoid:

• Evaluate whether such a risk is acceptable within your risk management. If the stop is too big, it is better to reconsider the entry.

• The optimal risk/reward ratio is at least 1:2.

• Do not set a stop by eye, use technical levels and volatility.

1.3 Constant change of stop-loss in the direction of increasing losses

When the price approaches the stop, some traders move it further, hoping for a reversal. As a result, a small loss turns into a big loss.

How to avoid:

• Before entering a trade, determine what kind of loss is acceptable. If the price reaches the stop, exit without a second thought.

• Remember: moving the stop in the direction of increasing losses is a lack of discipline.

1.4 Ignoring market conditions

Some traders set stops the same for all trades without considering current volatility and important news.

How to avoid:

• On days of high volatility, increase your stop but retain risk through decreasing position size.

• Take into account the market phase: in flat market the stops should be closer and in trending market the stops should be wider.

1.5 No stop loss

Many traders do not place a stop, hoping to exit manually. This often leads to catastrophic losses.

How to avoid:

• Set a stop in absolutely every trade, this approach over distance will prevent you from losing a significant amount of capital in a single trade.

2. Mistakes when using Take Profit

2.1 Setting Take Profit too close

Often traders are afraid that the price will turn around and set take profit very close. As a result, the profit is locked early and the price continues to move.

How to avoid:

• Use historical support and resistance levels.

• Apply a risk/profit ratio of 1:2 or 1:3.

• Check the volatility of the asset so that take profit is achievable.

2.2 Setting Take Profit too far away

Wanting to maximize profits, a trader sets the take profit too far away. As a result, the price does not reach the target and reverses.

How to avoid:

• Evaluate the realism of take profit using the average daily range of price movement.

• Break your take profit into several parts by taking some profits earlier.

• If the price moves in your direction, use a trailing stop.

2.3 No Take Profit

Some traders do not place a take profit, hoping to close the trade manually. As a result, greed gets in the way of locking in profits on targets.

How to avoid:

• Put take profit immediately after entering the trade.

• If you want to let the trade develop, use a trailing stop.

2.4 Closing a trade before take profit due to emotions

Traders, having seen a small profit, decide to close the deal before take profit, fearing to lose money. As a result, long-term statistics deteriorate.

How to avoid:

• Before entering a trade, define clear exit rules.

• If the trade is going according to plan, don't close it early without a good reason.

• Analyze your statistics to see how often an early exit results in missed profits.

3. Mistakes in Stop Loss and Take Profit Management

3.1 Ignoring the risk/reward ratio

Some traders risk 50 pips for 30 pips of profit, which leads to losses in the long run.

How to avoid:

• The minimum risk/profit ratio is 1:2. Optimally 1:3.

• If the take is too small and the stop loss is too large, it is better not to enter the trade.

3.2 Using the same Stop Loss and Take Profit for all trades

Some traders always set a stop loss of 30 pips and take profit of 100 pips without considering the specifics of the asset.

How to avoid:

• Adapt stop loss and take profit levels to the specific situation.

• Analyze market conditions before each trade.

3.3 Opting out of trailing stops

Some traders close profits manually without setting a trailing stop, which reduces profit potential.

How to avoid:

• Set a trailing stop to take maximum profits in a trend.

• Place the trailing stop at a reasonable distance so that it is not knocked out by market noise.

Examples of Stop Loss and Take Profit Usage

Example 1: Trading on currency pairs

Suppose a scalper buys RUB/USD at 1.1000. He sets:

• Stop Loss at the value of 1.0950 (50 pips down).

• Take Profit at 1.1100 (100 pips up). The risk/profit ratio is 1:2.

Example 2: Cryptocurrency trading

Buying an altcoin at a price of $50. Setup:

• Stop loss at $48 (-4%).

• Take profit at $55 (+10%).

Commonly used stop-loss and take-profit ratios are

• 1:1 - used for short-term strategies.

• 1:2 - standard ratio for risk management.

• 1:3 - a more conservative approach for profitable strategies.

Conclusion

Stops and take-outs remain indispensable tools for risk adherence and position management in trading. Their proper setting allows you to minimize losses and not miss the opportunity to lock in profits. Conscious use of these orders in combination with market analysis increases the probability of successful trades.

Frequently Asked Questions (FAQ)

1. Is it possible to change Stop Loss and Take Profit after setting?

Yes, but it is important to do so reasonably, based on market analysis.

2. What value of stop loss is considered optimal?

The optimal value varies from strategy to strategy, but it is recommended not to exceed 2-3% of the deposit per trade.

3. How to avoid closing a trade at stop-loss due to market noise?

Pay attention to the volatility of the asset and if it is high, then preferably place a stop-loss behind strong support or resistance levels.

4. Is it always necessary to set take profit?

Not necessarily, but it helps to lock in profits without emotional decisions.

5. Is it possible to trade without a stop loss?

Yes, but it increases the risk of significant losses. Experienced traders use alternative risk management techniques such as hedging.