Have you ever wonder why some traders open a position and don’t bother about checking it almost every minute, they use the “take profit and stop loss” mechanism. Most newbie traders don’t know how to use it or don’t even use it at all and we all at some point on our trading journey were caught in the circle too. Trading without setting a stop loss and take profit is very risky. Cryptocurrency trading is known for its high volatility and potential for significant profits.
Enter stop-loss and take-profit orders, two fundamental tools that every beginner trader should understand and utilize. These are not magical buttons that guarantee success, but they are powerful risk management techniques that can help you navigate the often-choppy waters of the market. Managing these risks effectively is important for both new and experience traders.
In this guide we will explain what these orders are, why they are important, and how to use them in the context of crypto trading. By the end, you’ll be well on your way to becoming a more disciplined and risk-aware trader.
What is a Take Profit Order?
A take profit (TP) order in cryptocurrency trading is an automatic instruction to close a trade once it reaches a predetermined profit level. Now take note of the word “automatic” which is done out of the traders consent once the the Take profit option is set in a trade even if the trader close the exchange he uses for trading and the asset he bought has approach the take profit level the order will be executed regardless, securing the profit without requiring the trader to be actively monitoring the market.
By setting a take-profit order, you lock in your profits and avoid the temptation to hold onto a winning position for too long, risking a reversal.
Greed is a powerful emotion that can cloud judgement. A take-profit order helps you secure your profits and prevents you from getting caught up in the hope of squeezing out every last bit of gain. The market can be volatile at any moment worst off if your trading memecoins on a derivative contract a profitable trade can quickly turn negative if you’re not careful.
For example, if you buy Bitcoin at $70,000 and set a take profit order at $75,000, the order will automatically sell your Bitcoin when its price reaches $75,000, ensuring you lock in a $5,000 profit per Bitcoin.
What is a Stop Loss Order?
A stop loss (SL) order is a defensive mechanism designed to limit an investor’s loss on a trade. It automatically triggers a sell order when the price of the cryptocurrency falls to a certain level. This helps prevent further losses by closing the position before the price can drop any lower. It is an instruction placed with the crypto exchange you trade with to automatically sell (for long positions) or buy (for short positions) a cryptocurrency once the price reaches a predetermined level. In essence, it acts as a safety net, limiting your potential losses on a trade.
The market is inherently unpredictable. Even the most well-researched and planned trades can go south. Stop-loss orders prevent emotional decisions. When a trade starts moving against you, the urge to hold on to a losing position in the hope of a turnaround is strong. A stop-loss order removes this emotional temptation from the equation. It ensures you exit the trade at a predefined price, mitigating potential losses.
For instance, if you purchase Ethereum at $3,800 and set a stop loss order at $3,500 the order will sell your Ethereum automatically if the price falls to $3,500 thus capping your loss to $300 per Ethereum.
The Importance of Take Profit and Stop Loss Orders in Crypto Trading
Risk Management
Cryptocurrency markets are notoriously volatile. The primary function of take profit and stop loss orders is to manage this volatility by limiting potential losses and securing profits. These orders help ensure that your losses do not exceed your risk tolerance and that profits are realized before the market can reverse. Setting the stop loss and take profit in cryptocurrency trading is crucial due to the market’s high volatility.
Effective risk management starts with setting a clear risk tolerance level, which defines how much of your capital you are willing to risk on a single trade or over a period, for most traders they prefer using 10% of their funds to invest in cryptocurrency. Utilizing stop loss orders is a fundamental risk management technique, automatically closing positions to prevent excessive losses. Position sizing, determining the number of units to trade based on risk per trade and total capital, helps in managing potential losses effectively.
Emotion Control
Trading cryptocurrencies can be highly emotional due to the rapid price swings. Fear and greed can drive decisions that are not in the trader’s best interest. Stop loss and take profit orders help eliminate the emotional component by automating the decision to close a trade. This disciplined approach can prevent impulsive reactions to market movements because figuring out when to exit the market is vital which is where stop-loss and take-profit levels come into play.
Strategy Implementation
Using take profit and stop loss orders can help in the consistent implementation of a trading strategy. These orders ensure that the strategy is followed even when the trader is not actively watching the markets, which can be particularly useful for those who cannot monitor their trades continuously.
How to Set Take Profit and Stop Loss Orders in Crypto Trading
Determine Your Risk-Reward Ratio
Before setting your orders, it’s crucial to establish a risk-reward ratio. This ratio represents how much you are willing to risk in relation to the potential reward. A common ratio used by traders is 1:2, meaning they are willing to risk $1 to potentially gain $2. This helps in ensuring that the potential profits justify the risks taken.
Stop-loss and take-profit levels are used to calculate a trade’s risk-to-reward ratio. The Risk-to-reward is the measure of risk taken in exchange for potential rewards. Generally, it is better to enter trades that have a lower risk-to-reward ratio as it means that your potential profits outweigh potential risks. Most traders seldom use 10% of their capital to trade.
You can calculate risk-to-reward ratio with this formula:
Risk-to-reward ratio = (Entry price – Stop-loss price) / (Take-profit price – entry price)
Analyze Market Conditions
Market analysis, including technical and fundamental analysis, can provide insights into where to set your take profit and stop loss orders. Key factors to consider include support and resistance levels, market trends, and volatility.
How to Calculate Take Profit and Stop Loss levels
Traders use various ways to utilize and determine the stop-loss and take-profit levels. These approaches may be used independently or in combination with other methods, but the aim is still the same: to use existing data to make more informed decisions about when to close a position. Support and resistance levels are areas on a price chart that are more likely to experience increased trading activity, be it buying or selling.
At support levels, downtrends are expected to pause due to increased levels of buying activity. At resistance levels, uptrend are expected to pause due to increased levels of selling activity. Together with the Fibonacci Retrenchment tool, the support and resistance pivots are great exit and entry point in a trade.
Traders who use this method typically set their take-profit level just above the support level and stop-loss level right below the resistance level they have identified.
Lets look into the fundamentals of Support and Resistance.
Moving Averages
This technical indicator sieves out market noise and smooths price action data out to present the direction of the current market trend. Moving averages (MA) can be calculated over a shorter or longer period, depending on individual traders’ suit. Because of how simple it is most traders monitor moving averages closely, looking out for opportunities to sell or buy presented in crossover signals, where two different MAs cross on a chart. The two most common cross over are the golden cross and dead cross.
A golden cross occurs when the 50- moving average goes above the 200-day moving average it is a very strong bullish reversal pattern. While a dead cross occurs when the 50-day moving average crosses below the 200-day moving average. Typically, traders using MA identify stop-loss levels below a longer-term moving average.
Percentage method
Instead of a pre-specified level calculated using technical indicators, most traders use a fixed percentage to determine stop loss and take profit levels. For instance, they may choose to close their position once an asset’s price is 5% above or below the price they entered. This is a straightforward approach that works well for traders who are not very familiar with technical indicators mostly newbie traders use this strategy.
But traders use many other indicators. This includes Relative Strength Index (RSI), which is a momentum indicator that signals if an asset is overbought or oversold generally assets below 30 are oversold and assets above 70 are overbought, Bollinger Bands (BB), which measures market volatility, and Moving Average Convergence Divergence (MACD), which uses exponential moving averages as data points.
Set the Take Profit Order
To set a take profit order, consider:
- Fixed Reward Method: Based on your risk-reward ratio, determine the profit level that corresponds to your desired reward. For example, with a 1:2 ratio, if your stop loss is set to risk $100, your take profit should aim for a $200 profit.
- Resistance Levels: Identify resistance levels (price levels where the cryptocurrency tends to face selling pressure) and set your take profit just below these levels. This ensures you capture profits before the price has a chance to reverse.
- Trailing Take Profit: Use a trailing stop to adjust the take profit level dynamically as the price moves in your favor. This allows you to lock in gains progressively while still giving your trade room to grow.
Practical Examples in Cryptocurrency Trading
Let’s assume you are trading Bitcoin, currently priced at $30,000. After analysis, you decide the following:
– Entry Price: $30,000
– Stop Loss: $28,000 (risking $2,000 per Bitcoin)
– Take Profit: $35,000 (targeting $5,000 profit per Bitcoin)
– Risk-Reward Ratio: 1:2.5
You set a stop loss order at $28,000 and a take profit order at $35,000. If the price drops to $28,000, your stop loss order will sell the Bitcoin, limiting your loss to $2,000 per Bitcoin. If the price rises to $35,000, your take profit order will sell the Bitcoin, securing a $5,000 profit per Bitcoin.
In Ethereum trading, let’s say you buy ETH at $2,500. After evaluating the market, you decide:
– Entry Price: $2,500
– Stop Loss: $2,300 (risking $200 per ETH)
– Take Profit: $2,800 (targeting $300 profit per ETH)
– Risk-Reward Ratio: 1:1.5
You place a stop loss order at $2,300 and a take profit order at $2,800. If the price falls to $2,300, the trade closes automatically, limiting your loss to $200 per ETH. If the price reaches $2,800, the trade closes, securing a $300 profit per ETH.
Common Mistakes to Avoid in Crypto Trading
One common mistake is setting stop loss orders too close to the entry point. This can lead to being stopped out by normal market fluctuations, resulting in unnecessary losses. It’s important to give your trades some room to breathe while still protecting your capital. Different cryptocurrencies have varying levels of volatility. Ignoring this can result in stop losses that are either too tight or too loose.
Adjust your stop loss levels based on the asset’s volatility to optimize your risk management strategy. While it’s essential to have a take profit level, overemphasizing it can sometimes lead to missed opportunities. Cryptocurrencies can sometimes trend strongly in your favor, and a rigid take profit order might close a trade prematurely. Consider using trailing stops to capture more profits in trending markets.
Cryptocurrency markets are dynamic, and conditions can change rapidly. Failing to adjust your stop loss and take profit orders as the market evolves can result in suboptimal trading outcomes. Regularly review and adjust your orders based on new information and market conditions.
Conclusion
Many traders and investors use one or a combination of the mechanisms above to calculate stop-loss and take-profit levels. These levels serve as technical motivations for them to exit or enter a trade, be it to abandon a losing position or realize potential profits.
Note that these levels are pivotal to each trader and do not guarantee successful performance. Instead, they guide traders in making informed decision-making, making it more systematic and robust. Therefore, mitigating risk by identifying stop-loss and take-profit levels or using other risk management strategies is a good trading habit.
Take profit and stop loss orders are indispensable tools in cryptocurrency trading. By understanding how to set these orders effectively and integrating them into your trading strategy, you can enhance your trading performance, control your emotions, and protect your capital. Remember, successful trading is not about eliminating risk entirely but about managing it wisely. Start small, test your strategies, and refine your approach as you gain experience.
