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Definition: Stop Loss

A stop loss is the short name given to a stop loss order (covered in section 3 of my “7 Steps to start day trading“) that is used to limit the potential loss in a trader’s existing position (in a stock, currency, futures contract, etc.).

Using stop losses in trading is ESSENTIAL. It is an important way for a trader to limit his losses in the market and avoid potentially catastrophic losses. Since no trader is infallible, a stop loss acts like an insurance policy when the UNEXPECTED occurs (please note that stop orders do not guarantee that a trade will be filled. If the market gaps through the stop price or if the liquidity in the market is reduced, it can result in a much worse fill than anticipated).

Even though some traders claim to trade using “mental” stop losses or “mental stops”, it is important that beginning traders get used to placing a physical stop loss order every time a new position is initiated. This will help active traders develop the discipline they need by desensitizing them to the “pain” of taking a loss.

“Where should a stop loss be placed?” is a commonly asked question in trading. Its answer depends on the type of trading strategy used and the volatility of the market being traded.

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