What are take-profit and stop-loss orders? How do they work?

What is a take-profit order?

A 'take-profit' order – otherwise known as a 'limit closing order' – is a type of limit order where you set an exact price. Your trading provider will then use this price to close your open position for profit. If the limit order does not hit the limit price, then the order remains inactive.

Many traders use take-profit orders collaboratively with stop-loss orders to manage the risk surrounding their open positions. If you go long on an asset and it rises to the take-profit point, the order is automatically executed and the position is closed for a gain. If the asset falls instead, the stop-loss order will be executed to minimise losses at a level attuned to your risk tolerance.

Accordingly, the difference between the asset's market price and your take-profit and stop-loss orders represents the trade's maximum risk–reward trade-off.¹

Imagine that a trader opens a long position on an asset and expects it to rise by 20%. They may place a take-profit order that is 20% higher than the bought-at price and a stop-loss order 5% below the bought-in price. This creates a favourable 5:20 risk-to-reward ratio, assuming the odds of each outcome are equal or skewed towards the upside.

What is a stop-loss order?

A 'stop-loss' order – officially known as a 'stop closing order' – is an order used by traders to limit loss or lock in the remaining profit on an existing position. It's a key tool used to manage risk on a trade.

Stop-loss orders carry instructions to close out a position by buying or selling an asset – depending on whether you're long or short – at the market when it reaches your set price. This is known as the stop price.²

Imagine that our trader buys an option on a stock and places a stop-loss order 5% below the purchase price. The stock subsequently falls by 5%, triggering the stop-loss, so the stock is sold at the best available price. If the trader had instead shorted the stock, the position would close through an offsetting purchase when the asset began to trade at the set price.

Why use take-profit and stop-loss orders?

There are multiple advantages to using both trading strategies, particularly in conjunction with each other. The key advantage is that these orders together limit total risk when placing a trade. However, like all trading strategies, there are some setbacks.

Advantages of take-profit orders

1. Traders don't need to track their trade through the day or second-guess themselves over how high (or low) an asset may go. This helps keep emotion out of the trade
2. Short-term traders can manage their risk because they can exit a trade the moment their planned profit target is reached. This means they don't have to risk a possible downturn
3. Take-profit orders can be placed at levels supported by technical analysis tools, such as chart patterns or money management systems
4. The automated nature of take-profit orders makes it easier to manage risk

Disadvantages of take-profit orders

1. Take-profit orders are executed at the pre-set price, regardless of the asset's behaviour. If it starts to break out higher, the order will still be executed, resulting in opportunity costs
2. Long-term investors using take-profit orders may reduce their risk, but this also reduces potential profits
3. Automating trades can be an excellent risk management tool, but it can also make traders lazy – so it's easier to make mistakes

Advantages of stop-loss orders

1. Stop-loss orders are a simple and intelligent way to manage the risk of loss on a trade. They also help to lock in a profit
2. Every investor can use stop-losses as part of their strategy, as they are easy to set and use
3. They add discipline to short-term trading and remove the emotions that often lead to converting a profitable position to a loss
4. They eliminate the need to continually monitor investments, which can be useful when you are away for extended periods

Disadvantages of stop-loss orders

1. If an asset suddenly gaps below or above the stop price, this triggers the order. This means the asset will be sold at the next available price, even if it's trading sharply away from the stop-loss level. For example, setting a stop-loss order at 5% for an asset which tends to fluctuate by 10% in a day is unlikely to be a sensible strategy
2. Traders can see their positions closed in a volatile market that rapidly reverses and resumes in a favourable direction. This can be avoided by combining it with a trailing stop. A trailing stop is an order whose stop price tracks the asset's movements and is set at a certain percentage/amount above or below the market price. Alternatively, you can pay a premium for a 'guaranteed stop', which as the name suggests guarantees a stop price
3. Long-term investors shouldn't worry about short-term market fluctuations in quality companies, instead regarding downturns as an opportunity to add to their positions
4. Stop-losses are not a cure-all for losses – poor investing decisions will still see you lose money, just at a slower rate. Every trade costs commission and small losses can mount up over time
5. Once you reach your stop price, your stop order converts into a market order. This means that the price you sell at can be different to the stop price when the market is moving fast. This includes when a position is held overnight – poor earnings results can see an asset open at the market below your stop price
6. There are sometimes assets for which you cannot place a stop order, including highly volatile penny stocks

How do you set take-profit and stop-loss orders?

1. Research your preferred market
2. Decide what you want to trade using technical and fundamental analysis
3. Open a trading account or practise on a free demo account
4. Select your opportunity
5. Set your position size and manage your risk by picking your price level, stop level and take-profits level
6. Place your deal

You can trade using take-profit and stop-loss orders using CFDs.

How do you calculate the best take-profit and stop-loss price levels?

Deciding the best price for both your take-profit and stop-loss orders depends on a huge variety of factors. By nature, these factors vary significantly from trade to trade. Examples include your personal risk appetite, the volatility of the security and your short-term and long-term investing goals.

Many traders use technical analysis tools, such as support and resistance levels, to help identify good prices for their entry point, take-profit and stop-loss levels. Some assets can be studied to recognise whether retracements are common, as these require a more active stop-loss and re-entry strategy.³

Overall, both take-profit and stop-loss orders are common, simple and effective tools that offer advantages to traders seeking to lock in profits while minimising excess losses. Both are thought of as trading insurance tools. In the worst cases, a stop-loss can prevent oversized losses when the unexpected happens, while a take-profit order protects a trader against a downturn that has already hit their price target.

However, take-profit and stop-loss orders aren't appropriate for every circumstance. For example, you wouldn't want to go this route for very long-term investments or when trading exceptionally volatile instruments.

Keep in mind that trading on CFDs is leveraged, which means you could lose money faster than you'd expect. Furthermore, past performance is not necessarily an indicator of future returns when using technical analysis, so you should always factor in how much you're willing to risk.

Take-profit and stop-loss summed-up

• A take-profit order is a type of limit order that specifies an exact price set by you. Your trading provider will close your open position for profit according to this price
• A stop-loss order is used by traders to limit loss or lock in the remaining profit on an existing position. It's a key tool used to manage risk on a trade
• Take-profit orders are useful to short-term traders who can manage their risk by exiting a trade the moment their planned profit target is reached, thereby avoiding a possible downturn
• Stop-loss orders are a simple and intelligent way to manage risk of loss on a trade. They also help to lock in a profit
• Calculating the best price to set for both usually requires a combination of technical and fundamental analysis

Sources

1. What Is a Take-Profit Order? – The Balance
2. Stop Loss Meaning: What Is Stop Loss & Its Benefits – Forbes Advisor INDIA
3. Stop-Loss vs. Stop-Limit: Differences, Benefits & Risks – Seeking Alpha