Keeping risk to a minimum in trading is always a good thing and guaranteed stops help you do that and should form a part of any sensible trade plan. However, they can also impact your profits over time. What do we mean by this? Guaranteed stops are great for setting an absolute limit on the risk for a trade but traders should be aware of the cost of this type of stop order.
Guaranteed Stops are mostly used in spread betting. But what is spread betting?
Just like the players on SparkProfit, spread bettors don’t actually buy and sell shares or commodities. Instead they bet on whether a market is going to rise (go long) or fall (go short).
So how is spread betting different from trading with a regular broker?
When a broker quotes you a price for a commodity or an FX pair they will give you two figures: the Bid and the Ask. The Ask is the price you can buy the share at right now from your broker (think: the price your broker is asking you to pay) and the Bid is how much you can sell it back to the broker ( or how much your broker will bid you to buy it).
For example, if a share is trading at 56/57 cents, this means you can can buy this share from your broker at 57 cents or the broker will buy it from you at 56 cents. This result of this is that if you buy this share from your broker at 57, you are immediately 1 cent down as your broker will only buy it back from you at that moment in time for 56.
This difference in price between the Bid and the Ask is called the ‘Spread’ and the size of the spread is caused by the difference in opinion between buyers and sellers.
It’s this difference of opinion that causes movement in the market; some people think the market is undervalued, some overvalued and so they want to either buy or sell. But if you don’t have enough money to actually trade commodities and FX with a broker, what can you do?
Instead of actually buying and selling shares, the spread bet provider enables their customers to bet on the direction of the market. You don’t need as much capital as normal investing to get started as your spread bettor provides you with something called leverage; leverage allows you to get exposure to large amount of a stock or commodity at a fraction of the cost of say a regular stock broker.. but the risks are huge.
Note that a spread-betting provider normally offers a slightly wider spread than a traditional broker. Hence the name spread bet.
The bettor makes money for each point the market travels in the direction they predict. For example, if they bet $10 long, they will receive $10 for each point the market rises and if they bet $10 short, they will receive $10 for each point the market falls. And just like SparkProfit, if you are good at predictions, you could make a lot of money. Let’s look at some examples.
Say you buy Brent Oil which is quoted by your broker at 4091/4095 (thats $40.91/$40.95); this means you can buy Brent Oil from your broker at 4095 or sell it to him at 4091. You put $10 a point on and you are now long Oil.
You predict right and Oil rises to 4115 so you decide to close out. Your profit is calculated as follows:
4115-4095 = 20 x $10 => $200
You make a profit of $200. That’s $10 a point over 20 points. That’s a good result, you made $10 for every cent Oil moved in the direction of your prediction.
Or did you?
In fact, the market had to travel 24 points to get you your $200 payout as the spread imposed by your broker actually put you in the market at 4091; so you would have begun your trade down by $40. Although you bought at 4095, your broker will only buy back your Oil contract from you at 4091 so you are effectively four points down.
You can also bet that the market will do down – or ‘go short’. If you go short with $10 at 4091 (the Bid price, which is what a broker will buy Oil from you at) and Oil falls to 4071 so you decide to close out, you also make a profit of $200 (4091-4071 = 20 x $10). Again, because of the spread, our Oil trade had to travel 24 points for you to get your 20 points of profit.
This is generally accepted by the trading community as the cost of doing business and, like any business, the trick to being profitable is to keep your costs down.
Slippage On Your Stops Takes All Your Money Over Time
This all makes it seem reasonably easy, doesn’t it? Going ‘long’ or ‘short’ on the markets and making money for each price movement in your favourite market. But it is high risk because you can easily lose a lot more than you put in. Much more in fact.
Take the first example again and go through a scenario where you lose the trade. You went long but the market dropped instead of rising. Let’s say you had a stop loss at 4071, which your broker managed to fill at the price you requested. For each point it drops you lose $10. With the same starting point, you are out of pocket by $200 (4091-4071 = -20 x$10). Bad result for you; the market moved 20 points in the opposite direction than you predicted. What adds insult to injury is that the spread actually reduced the distance price had to travel to hit your stop. With a spread of 4 points and a 20 point stop, you are only 16 points away from your stop, not 20.
Hopefully your broker got you out at the price you set for your stop loss but in a fast moving market, there is a very good chance that this is not the case. There is nearly always some difference, however small, between the price you wanted to get out of the trade at, and the price at which your broker managed to close the trade for you. In the case of your Oil trade, your stop order might have triggered at the price your requested ($40.71) but by the time the order gets filled by your broker, the price may have moved to $40.66. You just lost $250 rather than your planned loss of $200.
This is considered another cost of business and is termed ‘slippage’ by traders. Slippage is the difference in the price you wanted and the price you broker fills your trade at. And slippage can occur when you are trying to get into a trade at the price you want, and when you are trying to exit a trade. Slippage is common place and can be far worse than the example given above.
Slippage kills a trader’s profits over time.
Slippage does not need to be small; you could end up losing all your money on deposit with your broker if the markets really move.
This is one reason why putting a guaranteed stop loss on your bet is a good idea. If you want to limit your losses, the providers will make it sound like a no-brainer. With a guaranteed stop, your broker guarantees that the price you request for your stop loss will be the price that they get you out of your losing trade.
Stay safe – use a guaranteed stop… well, its not that straight forward. It’s not cheap.
To guarantee your stop loss, the provider will widen the spread of the market. So instead of, say, 4 points it could become 8. Just look at what that does to your profit margin.
In the regular spread bet before you’ve started you are 4 points down – that’s how the provider makes their money. You could say a regular spread is like starting a 100-metre sprint 4 metres behind the start line, and you need to work a bit harder to win. But with a guaranteed stop on an 8 point spread you’re a whopping 8 metres behind the start line and it’s going to be an uphill struggle to break even let alone cross the finish line ahead!
A guaranteed stops does give you safety, you will never lose more than you have staked on the trade; but what is the cost? Let’s look at the numbers and see what happens when you use a guaranteed stop.
Starting spread quoted by your broker for a guaranteed stop trade: 4091/4099
Market moves to your target: 4129
Stop loss at: 4070
Gain: $300 (4129-4099=30 @$10 per point)
Great result – you just made $300. To earn your payout though, you had to travel 39 points to hit your target not the 30 you may have assumed when getting into the trade. Also, if the trade had gone the other way on you and hit your stop, the price would only have had to have moved 21 points before you were stopped out rather than the 30. This is as a result of the wide spread imposed by brokers for guaranteed stop losses.
The odds have just been skewed well out of your favour.
That’s not your only problem. The price at which you can place your stop loss order gets pushed right back. To guarantee your loss, your provider will insist on you placing your stop loss further back than you might want. The end result of this is that you might have to place a larger trade than you might want to avail of the guaranteed stop.
So, with a guaranteed stop you are paying a lot extra with an increased spread and the distance you place your stop loss has increased. This increased cost of trading will eat into your profits over timee
When Guaranteed Stops cost so much and Stop Loss Orders don’t actually limit your losses to the amount you want, what is the small trader to do? For now, we think you should play it safe on SparkProfit. Even though you can’t trade your own money, you can win some. And we promise you can’t lose any with us either.
Sensible trading is all about reducing your downside risk as much as you can and guaranteed stops have their place in any trading plan – just be aware of the cost on your trading profits. Its more important not to over leverage on your trades, don’t risk too much on a single trade and have sensible stop loss distances; these are the keys to surviving in the long term as a trader. In general, if your risk on any one trade is over 3% of your total trading equity, you are risking too much. Some might even say that 3% is too much and many full time traders would recomend only risking 1% of equity on a day trade
Final thought – wouldn’t it be great if there were a way to trade that didn’t risk losing more than you decided to put on? Somewhere you could have serious fun without serious risk.