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The Benefits of using a Stop Loss in Crypto Trading
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Using a Stop Loss when trading has multiple benefits you may not have considered… read on to find out more!
What is a Stop Loss?
A Stop Loss is a common term used in trading that you may have heard.
Essentially, a Stop Loss is a set price or percentage of a price of an asset that when reached will automatically close your trade.
Did you know a Stop Loss also has additional benefits, such as:
- Protecting against “Lost Opportunity Cost”
- Sell for a small loss to buy more of the asset at a lower price (also known as a “Short”)
- Protecting your capital (particularly from Liquidation when Margin or Futures trading)
- And you can even trail your Stop Loss to achieve more profit while minimizing your risk
We’ll discuss these points above in further detail throughout this article.
Traditional Stop Loss
In the example of a “Long” trade, when you buy an asset lower and plan to sell it higher to make a profit, the Stop Loss is initially placed beneath the purchase price of the asset, so if price moves down rather than up, the trade is closed and your capital is returned minus the difference that was realized.
Example: You start a trade by purchasing 1 ETH for $1000. You would like to take profit and sell the 1 ETH when the price reaches $1100, yielding 10% or $100 profit on your initial investment (less fees). However, if the price falls, you are trapped in a trade where the 1 ETH you purchased is decreasing in value, and selling 1 ETH for anything less than the $1000 you initially invested results in a loss… this is where a Stop Loss can help you plan for and mitigate this risk..
As Cryptocurrency prices can be very volatile, prices can fall dramatically in moments which does not give a trader or investor an opportunity to react., This is where a pre-set Stop Loss can help protect your capital while you sleep or go about your everyday life.
With 3Commas SmartTrade, you can define a Stop Loss condition at the time of your trade that will automatically sell the assets you are holding should prices fall below a threshold you set.
Why would I want to sell for a Loss?
Cryptocurrency markets are cyclical. Often when prices fall dramatically on an asset, prices can reverse and rise quickly (this can be minutes/days/weeks). Some traders believe that holding (also known as “hodl’ing”) on to an asset as price falls is better than selling for a loss, as prices will eventually recover. They may also employ “Dollar Cost Averaging” (DCA) strategies to buy more of the assets at specified intervals as price falls further. This can be an effective strategy if you have additional funds you are investing or speculating in assets you believe have very strong potential to rise much higher in price over a longer period.
However, every strategy has its downfalls, and this is not a good strategy if you have a limited amount of funds, as they can be stuck in a losing trade for a long period of time – even if the trade eventually turns around and closes in profit (this is known as “Lost Opportunity Cost”, or the time that you could have made profits with your assets elsewhere). The psychology of a trader comes into play here; some people think that any loss is a bad thing and might have the unrealistic expectation that all trades must, or will be, successful. We’re here to tell you now that this is not possible,, and even the best traders in the world do not have 100% win-rates.
The Cost of Lost Opportunity
With the above example in mind, holding on to a trade or asset that may have fallen sharply in value (say -30% or more), is not the best course of action if you are a trader with a smaller account. In this same scenario, let’s say you had taken a small loss of 2-5%. By closing the losing trade earlier when prices started to decline, you would have your capital available to invest in better trade opportunities on assets that are rising in value, essentially recuperating the lesser loss of 2-5% versus holding a loss of 30%. This is where our bots come in and can help to earn you continuous profits in spite of market conditions!
Traders or investors with larger accounts might also benefit from selling an asset in their long-term investment portfolio for a small loss as they can actually increase the amount of the asset by buying a larger quantity back at a much lower price, the 3Commas “Smart Cover” is a powerful tool to use in this situation.
A Stop Loss here would have allowed the trader to double their Bitcoin holdings by re-purchasing at a lower cost.
Trailing your Stop Loss for greater profits and less risk
In some situations a Stop Loss can be used to guard profit you have made in an asset as price rises from where you originally purchased it at. You can manually “move your Stop up” (as it is commonly referred to). This is where your asset, for example, has risen 10% in value and you raise the Stop Loss to break-even (the price you originally bought the asset for) or even into profit.
If the trade or investment is performing very well, you may continually move the Stop Loss price up every day or week, to ensure that if the price reverses, your trade will close in profit or break-even and you can assess the next trade you wish to make knowing your funds were protected.
3Commas SmartTrade tools also have the ability to automatically “trail” the Stop Loss value for you by a fixed percentage below the current chart price. As price rises, so will your Stop Loss price. If the asset falls below the threshold you set, the trade is closed. Either way, 3Commas enables you to “set and forget” your trade, alleviating some of the emotions associated with trading cryptocurrencies.
Protecting your capital from Liquidation when Margin or Futures trading
When trading using leverage on Futures or Margin exchanges, you are trading with funds you have borrowed, sometimes by as much as 100 times the capital you have available.
This is incredibly risky as you can be liquidated or “margin called” if the trade enters a loss.
For example, if you created a Long trade with $1 using 100x leverage, you will create a position on the contract being traded for $100. If the price rises by 1% and you close the trade, then you will make $1 profit, effectively doubling your original $1 investment.
However, the additional risk of leverage is that if the price falls 1% then your trade will be liquidated and you will lose the $1 you initially invested.
There are typically two types of Futures or Margin leverage modes offered by exchanges; “Isolated” and “Cross”.
Isolated leverage mode is where the funds used to open the position have a preset amount of margin (calculated when the position is opened), and once this margin is used, the position is liquidated and the amount of funds risked to create the trade are lost. This mode will only risk the amount funds used to create this specific position on the exchange.
Cross leverage mode allows traders to use any unspent balance in their exchange account as margin for any positions they open on contracts; the benefit being that this can greatly offset the liquidation price of trades but with the increased risk that if a trade is liquidation, the entire amount of funds they hold on the exchange account will be lost.
It is therefore critically important to always use a Stop Loss when trading on Futures or Margin exchanges to guard against the possibility of a trader’s entire account from being liquidated.
A Stop Loss can not only prevent further risk to your capital, but can also be used to safeguard profits on the assets you hold or your profitable active trades.
We hope this article has helped improve your knowledge on Stop Losses and the various ways they can be employed to improve your trading and investing to help maximize your profitability. As always, please reach out to our support team if you ever need help via [email protected].
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