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The Stop Loss & Stop Limit

by Kenny LiFebruary 22nd, 2018

Too Long; Didn't Read

When it comes to a market as volatile as cryptocurrency, the hardest part is to mitigate your losses. Especially with the recent crash that Bitcoin has experienced, many novice investors have quickly learned the importance of controlling losses — some may have, unfortunately, had to learn it the hard way. Even in the recent market, Bitcoin has been struggling to break past $12,000, frequently correcting back below $10,000.

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The Power of the Stop Loss and the Strategies Behind It

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The past few months have been quite a roller coaster for Bitcoin (source: CoinLib)

Fortunately, there’s a solution to tell an exchange such as GDAX (owned by Coinbase), Bittrex, or Binance to automatically sell at a certain price or below. For those of you unfamiliar with trading, it’s called a Stop Loss. For those of you looking for a more technical definition, Investopedia sums it up pretty well:

A stop-loss order is an order placed with a broker to sell a security when it reaches a certain price. Stop loss orders are designed to limit an investor’s loss on a position in a security. Although most investors associate a stop-loss order with a long position, it can also protect a short position, in which case the security gets bought if it trades above a defined price.

Stop losses are great, and can assist in a variety of ways including:

Preserving your money: preventing loss of any of your initial investment by automatically liquidating (cashing out) immediately when the price drops back down to your buy-in price (or a little above your buy-in price if you want to consider the transaction fee costs, too).
Preventing a bad situation from turning worse: keeping you from losing more money than you feel comfortable with losing; i.e., giving yourself some wiggle room while you wait for your investment to, hopefully, grow.
Making at least some profit: guaranteeing profits while you wait for the candlestick to grow even bigger (the green candlestick, of course). If you don’t know what a candlestick is, check out my article on 0 to Pro Crypto Trader to learn all about it.

Using a good stop loss strategy can make you look as cool as the guy sipping his scotch in that GIF (how do I know it’s scotch? All cool guys who know how to set stop losses drink scotch). Yes, there is strategy behind the stop loss.

Sure, noobs will just bang the keyboard and hope their money is still there tomorrow, but no, not you — you’re ready to make some smooth love to the charts. So here’s some sexy stop-loss techniques that can definitely make you the talk of the table.

The Full Stop Loss

This is the most generic kind of stop loss. It’s what people think of when they see the stop loss button. This strategy is black-or-white — you either wake up with your bitcoins (or altcoins) or you don’t.

For example, Billy has 1 BTC and is worried that bitcoin will fall below $9,000 while he’s asleep. So he sets a stop loss rule that tells the exchange to automatically sell his 1 BTC if price drops below $9,000. The advantage of this is that if the price does, indeed, drop below $9,000 and stays there, Billy has just saved himself from losing more than he intended to and can buy back in at a lower price.

The disadvantage, though, is that it leaves him completely exposed to the possibility that BTC could rise above $9,000 again before he wakes up. Therefore, he would have to buy back in at a price above $9,000, meaning he has suffered a loss.

Partial Stop Loss

So Billy starts thinking about how to defend against the disadvantage present in the full stop loss. While there isn’t a perfect answer, the partial stop loss is a compromise. Still a black-and-white solution, with a partial stop loss, Billy would set a rule that only, perhaps, 50% of his holdings get sold if the price drops below $9,000.

If the price rises above $9,000 — let’s say, to $10,000 — then at least he still has half his BTC to take advantage of the higher price, and he then has more flexibility to make his next move. One possibility is that he could immediately buy back in, which would result in less of a loss than if he immediately bought back in through the Full Stop Loss strategy. Another possibility is that he can sell the remaining 0.5 if he believes the price will drop back down, and then buy in again at a lower price. To any extent, if he employs the Partial Stop Loss strategy and the price moves back up, he would have come out ahead compared to the Full Stop Loss.

The disadvantage, though, is that if BTC falls below $9,000 and stays below $9,000, then Billy would have only liquidated half his holdings. If he then sells the remainder of his shares below $9,000, then it would be a heavier loss compared to the Full Stop Loss.

Trailing Stop Loss

Alright; by now, Billy’s on the Limitless drug and his creativity has reached a new record-breaking high, unlike Bitcoin, which is potentially going to crash again soon so he really needs to start thinking.

One of the problems of the Partial Stop Loss (or even the Full Stop Loss) is figuring out where to set the trigger. For example, let’s say the current price of Bitcoin is $10,000. Billy thinks it’ll go down to $8,500. He decides to set a stop loss at $9,200. This way, if it hits $8,500 in the morning, he can buy back in for 1 BTC at $8,500 again and pocket the remaining $700 (or buy more BTC with it — let’s face it, that’s what Billy would do because Billy is you and me and we aren’t self-control prodigies).

But if the price only goes down to $9,000, then setting the stop loss at $9,200 would’ve been a bit low and he would have missed out on taking advantage of a larger spread (in this case, the spread is defined as the difference between the price you sold and the current price).

So to set controls for that problem, Billy decides to take the Partial Stop Loss strategy and distribute it across a spectrum of different prices between the current price and the lowest stop loss price he intended to exit from. By this time, people only know him as Bill.

In this way, hitting each stop loss would help with dollar cost averaging his exit; for those of you unfamiliar with dollar cost averaging, it is a strategy where you take out money little by little between a certain price and your intended exit price, in an effort to increase the average price you exited at.

For example, look at the same scenario, let’s say Bitcoin is $10,000, and Billy thinks it’ll go down to $8,500. But he’s unsure, so he would rather play it more conservatively on the chance that it either jumps back up or doesn’t go all the way down to that price. In a very basic scenario, instead of setting a single stop loss trigger at $9,000, he might set a stop loss trigger to sell 0.2 BTC at $9,800. Then another 0.2 at $9,600. Then another at $9,400… and $9,200… and $9,000. This way, his average exit price would be $9,400 instead of $9,000. If it hits only $9,000, he would still make $400 off the spread, instead of $200 from the previous example of only setting a single stop loss.

Which One Should I Use?

All programmers will know this answer too well: it depends.

With each of the three stop loss strategies, the advantages and disadvantages were described only as it fit with the example scenarios. The reality is, there could be several arguments made about the strengths and weaknesses of each strategy that are not included in this article.

At the end of the day, though, the strategy you should deploy when trying to swing trade or short the bear market (both are very risky strategies) depends on your confidence around the potential prices of Bitcoin in the near future.

Resources to Help You

Crypto trading is 20% markets and 80% mind games.

Trading is a mind game. Most of the time… you’re not trying to beat Bitcoin. And you’re not trying to out-smart the markets. You may think that’s what you’re doing.

But the fact is, most of the time, the game is really a psychological battle between your logic and your emotions. The Stop Loss is a tool to help you with risk mitigation, and it can certainly assist in reducing losses during this turbulent time with Bitcoin and the cryptocurrency market. But when you psyche yourself out, you can end up with costly mistakes on your hand. These mistakes include selling too early, buying back in too early, buying back in at a loss and then watching it plummet back down again for even more loss… The list goes on.