Stop loss is a limit that acts as a safety valve if something starts to go wrong with a trade or a position. Specifically, it is the amount that a portfolio’s single- period trading or mark to market loss should not exceed. These limits state that specified action (reduction in exposure or close out position) must take place if the loss exceeds a threshold amount.
Tight stop loss limits reduce the maximum possible loss and therefore reduce the capital required. However, if the limits are too tight they reduce the trader’s ability to make a profit.
The art of setting stop loss limit therefore lies in determining the right balance between risk, reward and limits. Stop loss limits are therefore calibrated on a more frequent basis than market risk policy documents. Primarily because market risk volatility levels change on a daily basis. When market and price volatility is high, stop loss limits are tightened. When market and price volatility is low, stop loss limits can be relaxed.
Stop loss orders are orders that come into play when a stop loss limit is breached. They turn limit order linked to a market price into market orders that can then execute at the available market price if the stop loss threshold has been hit.
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