TL;DR
Stop-loss and take-profit levels are two fundamental concepts that many traders rely on to determine their trade exit strategies depending on how much risk they are willing to take. These thresholds are used in both traditional and crypto markets, and are especially popular among traders whose preferred approach is technical analysis.
Introduction
Timing the market is a strategy where investors and traders try to predict future market prices and find an optimal price level to buy or sell assets. Under this approach, figuring out when to exit the market is vital. That’s where stop-loss and take-profit levels come into play.
Stop-loss and take-profit levels are price targets that traders set for themselves in advance. Often used as part of a disciplined trader’s exit strategy, these predetermined levels are designed to keep emotional trading to a minimum and are essential to risk management.
Stop-loss and take-profit levels
A stop-loss (SL) level is the predetermined price of an asset, set below the current price, at which the position gets closed in order to limit an investor’s loss on this position. Conversely, a take-profit (TP) level is a preset price at which traders close a profitable position.
Instead of using market orders in real-time, traders can set these levels to trigger automatic selling without having to monitor the markets 24/7. Binance Futures, for example, has a Stop Order function that combines stop-loss and take-profit orders. The system decides if an order is stop-loss or take-profit based on trigger price levels and last price or mark price when the order is placed.
Why use stop-loss and take-profit levels?
Exercise risk management
SL and TP levels reflect the market’s current dynamics, and those who know how to properly identify their optimal values are essentially identifying favorable trading opportunities and acceptable levels of risk. Evaluating risk using SL and TP levels can play a crucial role in preserving and growing your portfolio. Not only are you systematically protecting your holdings by prioritizing less risky trades, but you are also preventing your portfolio from being wiped out completely. Therefore, many traders use SL and TP levels in their risk management strategies.
Prevent emotional trading
One’s emotional state at any given moment can heavily affect decision-making, and this is why some traders rely on a preset strategy to avoid trading under stress, fear, greed, or other powerful emotions. Learning to identify when to close a position can help you avoid trading on impulse, allowing you to manage your trades strategically rather than whimsically.
Calculate risk-to-reward ratio
Stop-loss and take-profit levels are used to calculate a trade’s risk-to-reward ratio.
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.
You can calculate risk-to-reward ratio with this formula:
Risk-to-reward ratio = (Entry price - Stop-loss price) / (Take-profit price - entry price)
How to calculate stop-loss and take-profit levels
There are various methods that traders can utilize to determine optimal stop-loss and take-profit levels. These approaches may be used independently or in combination with other methods, but the end goal is still the same: to use existing data to make more informed decisions about when to close a position.
Support and resistance levels
Support and resistance are core concepts familiar to any technical trader in both traditional and crypto markets.
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, uptrends are expected to pause due to increased levels of selling activity.
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.
Here’s a detailed explanation of The Basics of Support and Resistance.
Moving Averages
This technical indicator filters market noise and smooths price action data out to present the direction of a trend.
Moving averages (MA) can be calculated over a shorter or longer period, depending on individual traders’ preferences. 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. You can read about Moving Averages in detail.
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, some traders use a fixed percentage to determine SL and TP 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.
Other indicators
We’ve mentioned a few common TA tools used to establish SL and TP levels, 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, Bollinger Bands (BB), which measures market volatility, and Moving Average Convergence Divergence (MACD), which uses exponential moving averages as data points.
Closing thoughts
Many traders and investors use one or a combination of the approaches above to calculate stop-loss and take-profit levels. These levels serve as technical motivations for them to exit a trade, be it to abandon a losing position or realize potential profits. Note that these levels are unique to each trader and do not guarantee successful performance. Instead, they guide decision-making, making it more systematic and robust. Thus, evaluating risk by identifying stop-loss and take-profit levels or using other risk management strategies is a good trading habit.