- A stop-loss level is a predetermined level where a trader places a sell order in order to prevent further losses from a losing position.
- A take-profit level is a predetermined level where a trader places a sell order in order to realize gains on a winning position.
- Stop-loss and take-profit levels help with risk management, preventing emotional trading, and determining a trade's risk-to-reward ratio.
- Common methods for calculating stop loss and take profit levels include support and resistance levels, moving averages, and fixed percentages.
Learning to time the market can be a tricky proposition, especially in the world of crypto where volatility is high, liquidity is low, and market conditions can change at the drop of a hat. For this and other reasons, traders employ a variety of methods to help predict future market prices and take advantage of the optimal price levels to buy or sell assets.
Two of the most popular methods to employ are take-profit and stop-loss levels, which can help take emotion out of the equation and assist traders with selling a token automatically at predetermined levels. But what is stop loss and take profit? These predetermined levels are a key part of any disciplined trader’s exit strategy and are an essential part of risk management.
Stop Loss and Take Profit Levels
What is stop loss vs take profit? A stop-loss (SL) level is a predetermined price level for an asset, set below the current price, where a trader places a sell order that would liquidate a position in an effort to limit the potential losses. On the flip side, a take profit (TP) level is a preset price, above the current price, where a trader puts a sell order to close a profitable position.
Utilizing stop-loss and take profit levels makes it so that a trader doesn’t need to be glued to a price chart at all times, allowing them to set sell orders that will trigger automatically, anytime, day or night. The 24/7 nature of the crypto market makes these tools especially useful since they are programmed to trigger no matter the time.
Why Use Stop Loss and Take Profit Levels?
Risk Management
Take profit and stop loss levels are a reflection of the current dynamics at play in the market and allow those that know how to properly use them to identify favorable trading opportunities with acceptable levels of risk. Employing stop-loss and take profit levels is an important part of risk management as they assist you in preserving and growing the size of your portfolio.
SLs limit the amount of downside risk a portfolio will experience, which is the opposite of the popular HODL mentality of some in the crypto community who will hold an asset all the way to zero. TP levels ensure that you capture some of the achieved upsides before the volatile crypto market turns against your position and wipes any gains off the chart. For these reasons, SL and TP levels are important risk management tools.
Prevent Emotional Trading
It's often said that a trader's worst enemy is themselves, but it may be more precise to say it's their emotional state. At any given moment, a person’s emotional state can heavily affect decision-making, and moods can change as quickly as the direction of the crypto market. For this reason, employing various strategies – including SL and TP levels – can help investors avoid trading under stress, fear, greed, or other powerful emotions.
Learning how to determine reasonable levels to close a position can help to avoid trading on impulse, allowing you to employ a strategic plan for asset management rather than an unplanned mess that results in losses.
Determining Risk-To-Reward Ratio
Stop-loss and take-profit levels are handy when it comes to calculating a trade’s risk-to-reward ratio – which is the measure of risk taken in exchange for potential rewards.
Generally speaking, it's optimal to enter trades that have a lower risk-to-reward ratio as it implies that the potential profits outweigh the potential risks.
A risk-to-reward ratio can be calculated using the following formula:
Risk-to-reward ratio = (Entry price - Stop-loss price) / (Take-profit price - entry price)
How to Calculate Stop-Loss and Take-Profit Levels
Need help figuring out how to calculate stop loss and take profit? There are a variety of methods that traders utilize to determine optimal stop-loss and take-profit levels for a trade. They can be applied independently or in combination to help determine these levels, but they all utilize existing data to make a more informed decision about the ideal time to close a position.
Support and Resistance Levels
Key concepts to understand when doing technical analysis in both the traditional and crypto markets are support and resistance levels – and how they help you navigate an asset's price action.
Support and resistance levels are areas on a price chart that are more likely to experience increased trading activity. When prices are rising, the amount of selling tends to increase as the price gets closer to resistance, which can lead to a pause in the uptrend. When prices are falling, the amount of buying tends to increase as the price gets closer to support, which can lead to a pause in the downtrend.
Traders who use support level to determine their stop-loss level typically place it just above the support level, while those who use resistance to determine a take-profit place it right below the resistance level they have identified.
Moving Averages
Moving averages (MA) are technical indicators that help to reduce market noise by providing a smoothed line that represents an asset’s price action data and provides insight into the direction of the current trend.
MAs can be calculated for both short and long periods of time, depending on the individual traders’ preferences. Traders keep a close eye on moving averages to help identify opportunities to buy or sell – usually represented in crossover signals – which is when two different MAs cross on a chart.
MAs can be used to help traders identify stop-loss levels below a longer-term moving average.
Percentage Method
Some traders prefer to use fixed percentages to determine SL and TP levels as opposed to pre-specified levels calculated using technical indicators.
For example, they may set a take profit/stop loss order at a price that is 10% above or below the price where they entered the position. This is a simple, straightforward approach that works well for new traders who are not yet familiar with how to use technical indicators.
Other Indicators
There are a multitude of other indicators aside from those that are listed here that traders like to use to determine SL and TP levels. Some common ones include the Relative Strength Index (RSI), which is a momentum indicator that signals if an asset is overbought or oversold, Bollinger Bands (BB), which measures market volatility, and Moving Average Convergence Divergence (MACD), which uses exponential moving averages as data points.
