Take-Profit & Stop-Loss Orders: How Do They Manage Risks?
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The trading landscape is all about controlling impulses and sticking to a consistent strategy. Even the most successful and high-margin investors make a concerted effort to be patient and risk-averse in most cases. Without playing it safe, your trading portfolio could incur significant losses in a short period.
This article will discuss two of the most established mechanisms to manage risk in the trading landscape - Stop-loss and take-profit orders. These risk management practices are designed to keep traders from going down with a failing investment or losing out on a short window of profitability. Let's discuss further.
Key Takeaways
Take-profit order enables traders to automatically sell their purchased assets after it has reached a certain appreciation level.
A stop-loss order minimises losses by selling a tradable asset after depreciating to a certain amount.
Both mechanisms ensure that traders follow consistent trading strategies and avoid impulsive decisions.
What is a Take-Profit Order?
Take-profit order is a digital mechanism that automatically sells a particular asset after it has reached the predetermined market value. It is a tremendous self-controlling solution for traders who wish to capitalise on consistent trading strategies and avoid missing out on profit opportunities.
Numerous investors employ the take-profit solution to limit faulty decision-making scenarios. To understand the significance of the take-profit order, it is crucial to realise the opportunistic nature of the trading markets. If simplified to its core, trading can be similar to the betting practice, where participants bet on a specific asset to be successful.
Once the price of a particular asset starts to go up, it is challenging to stay disciplined and sell it before the valuation starts to drop. After all, no one knows how high a given asset's valuation could go up, and many investors risk losing out on profits due to the described anxiety. Take-profit order is a great mechanism to control this irrational instinct and help traders execute their predetermined strategies.
How does the Take-Profit Order work?
Utilising the take-profit order is quite simple, even for newcomer traders. The entire process involves selecting a desired asset and determining the profit target. Suppose investor X has purchased asset A to sell it later with a 10% profit margin.
After a few months, asset A has reached 110% of its initial value. However, the price is going strong, and some traders believe another 10% growth is likely in the next month. Without the take-profit safeguards, investor X might decide to take a risky approach and keep holding the asset.
As the next month goes by, asset A ceases to grow abruptly and even falls under its initial value. As a result, investor X has not only missed out on their 10% profit opportunity, but they have also incurred losses on the initial investment.
Conversely, if investor X utilised a take-profit mechanism, the scenario would progress differently. With this approach, investor X sets a predetermined profit target related to the trade entry price. In this example, the profit target is 110% of the initial investment. Once the asset reaches the target profit value of 110%, the take-profit order will be executed automatically, relieving the investor of a tough decision. As a result, investor X will receive a 10% yield on this trade instead of generating losses.
The above example perfectly illustrates the power of take-profit orders and their ability to increase the risk-to-reward ratio significantly. While this mechanism might force traders to lose out on high-yield trading opportunities, it also minimises the loss scenarios dramatically. And, considering that the negative outcomes are far more likely compared to the significant price spikes, the take-profit order is a consistently effective mechanism. However, it is still up to the traders to determine the take profit levels, which gives them the flexibility to choose the endgame for a certain tradable asset.
What is a Stop-Loss Order?
While the take-profit order is an excellent tactic to capitalise on profit windows, the stop-loss order is an outstanding option to mitigate losses. In many cases, the purchased assets might turn into losing investments, dropping significantly below the initial purchase price. In this case, traders might experience another human bias, irrationally hoping that the underlying asset will eventually rebound and increase in value again.
While this might be true in some circumstances, traders should not prioritise unfounded optimism over pragmatic decisions, and stop-loss orders are here to ensure just that. With the stop-loss mechanism, traders can set a predetermined selling price for their assets. For example, if investor X purchases asset A at $ 50 per unit, they can select a stop-loss order of $45.
As a result, if asset A falls to a $45 valuation per unit, the stop-loss protocol will automatically sell it from investor X's portfolio. Thus, investor X will not be tempted to make an irrational decision and keep asset A despite diminishing returns.
The Significance of the Stop-Loss Order
As outlined above, a stop-loss order is one of the best risk management techniques in the trading market, letting traders control their impulses and execute long-term strategies flawlessly. Without stop-loss support, even the most experienced traders could fall victim to irrational judgment, deciding that a particular asset is worth keeping even after significant price drops.
Like the take-profit orders, the stop-loss approach will not always yield the best possible results, as investors might be right in certain scenarios. However, in aggregate, it is much more secure and diligent to employ the stop-loss approach. Stop-loss is even more crucial in the case of full-time traders since the law of averages dictates that risk mitigation is the best practice to follow in case of failing investments.
The Risk Management Strategies Derived from Both Orders
As discussed above, take-profit and stop-loss orders are excellent solutions for experienced and newcomer traders. Both practices are easily available on any popular online trading platform. After setting up a trading account, investors can seamlessly adopt both mechanisms and start trading within the predetermined safety zones.
Moreover, it is best to combine these two practices since they create a balanced risk mitigation strategy. If the asset price increases, a take-profit order will ensure investors capitalise on the increased value. A stop-loss will limit losses to a predetermined number if the price decreases. Together, these mechanisms minimise the factor of irrationality and impulse in the decision-making process of traders.
Final Takeaways
One thing unites all traders across the globe, regardless of their experience and knowledge - human nature, which is prone to be impulsive from time to time. To avoid trading decisions caused by impulse, traders can employ stop-loss and take-profit orders.
Both strategies are excellent trading stabilisers, allowing investors to stay on track and avoid making hasty or delayed decisions. Whether you trade in financial markets, commodities or even crypto, it would be diligent to consider adopting these two practices.