The meaning of stop loss and take profit: the art of closing

When it comes to trading, it is essential to learn the meaning of stop loss order and take profit order (SL/TP), two ways of selling or closing a position that beginners need to know. When starting out, it is crucial to understand the risks involved in this activity, and in view of this it is not only necessary to envisage a strategy with which to approach the market, but also one (or more) exit strategies: how to close your positions while realising the lowest possible losses thanks to risk management.

Limit order and stop order

Stop loss and take profit are terms commonly used to indicate two types of sell orders: the first via stop orders and the second via limit orders.

If you have never used a professional exchange, you are probably only experienced in the use of market orders, i.e. purchases and sales set up and executed at the same time, at the first available price.

Limit and stop orders, on the other hand, allow you to set the price and trade only when the market reaches the desired valuation, automatically. In this way, you do not need to be constantly connected to the market, but only need to set execution conditions for your trades.

To better understand not only the meaning, but above all the difference between stop loss and take profit, we recommend reading the article on supports and resistances.

What is stop loss order (SL): meaning and risk management

As the word indicates, the meaning of stop loss is nothing other than a selling stop order. 

The first purely technical aspect to consider is that, unlike a limit order, reaching the stop price does not imply buying and selling at that price, but the execution of a market order, which could then be completed at a yet another price.

A sell stop order, or stop loss order, is usually used in a bearish scenario, and the stop price will mandatorily be set lower than the current market price.

Stop orders are used when the current trend is expected to continue, breaking support or resistance lines.

Since in this case we are talking about exiting the market and therefore selling (except if you are margin trading), we focus on the prospect of breaking support, i.e. a price range below the current one.

The main purpose of the SL, as the term indicates, is to limit losses. It is therefore not aimed at profit: it is used to avoid going negative beyond what you can afford in the event of a support breaking.

According to some risk management methods, this order should be opened at the same time as entering the market with a purchase, in order to protect yourself against losses that could be caused at any time by an unwanted price reversal.

The correct positioning of the SL is a much discussed topic and depends heavily on the type of market you are trading on. Let us now look at the difference between stop loss and take profit by delving into the latter trading order.

What is take profit (TP): meaning

The take profit order, unlike the stop loss, is based on the limit order mechanism, and also consists of a sale or liquidation of the position. This is why it can also be called a sell limit. 

The fact that TP is a limit order implies that the execution price, also called the limit price, must be higher than the current market price. 

As the meaning of take profit suggests, this type of trade is used with the aim of exiting a position at a profit. The scenario in which it is usually set is as follows: a trend reversal and a subsequent test on the resistance line are expected.

It is precisely at this point that you want to execute the sale, before the price is pushed back below resistance.

How to set stop loss order and take profit: SL/TP risk management

Successful stop loss order and take profit trading implies a correct identification of supports and resistances, and in general an accurate technical analysis of the price.

Moreover, the choice of these two positions must depend on your objectives and level of risk. Therefore, it is always necessary to have a target return and a maximum loss that you are willing to suffer before starting to trade, i.e. a risk management strategy.

In particular, the difference between the market price and the price of these two orders makes it possible to calculate the risk-return ratio of a position and assess whether it is within your ‘comfort zone’.

Let’s take an example: let’s imagine that a trader notices a double bottom in the bitcoin price chart, indicating that the price has touched support twice and could go on to create a W-shaped pattern, resulting in an upward trend reversal.

The trader opens a buy position at the current price of €50,000, and now has to choose their exit strategy. 

Should their hopes come true, BTC could enter the €55,000 resistance area: thus they set a take profit at €60,000 according to their profit target. This would mean +20%.

If, however, this prediction does not come true, they have to protect themselves: if the price touches support a third time, and breaks it at €48,000, losses are assured. So they set a stop-loss at €47,500, i.e. 5% below the current market price.

The choice of these percentages is entirely subjective, but the calculation of the risk-return ratio is entirely objective: it is a 5:20 ratio.

By foreseeing these two possible scenarios in advance, and knowing what they mean, the trader only has to set these orders and wait for the actual outcome by having already configured and timely reactions.

By having a clear strategy that takes into account their level of risk, and by knowing the meaning of stop loss and take profit as risk management tools, the trader becomes independent of the emotionality and cognitive biases aroused by the surrounding market.