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What is a Take-Profit/Stop-Loss order?

A Take Profit/Stop Loss order is used to exit an existing position and can only be placed during regular trading hours. One of the reasons that swing traders activate Take-Profit/Stop-Loss orders is because pre-setting Take-Profit and Stop-Loss prices can mitigate the risk of letting emotion influence your decision about when to exit a trade.

• A Take-Profit order is used to protect profit on an existing position once the stock reaches a specified price. It is filled as a limit order when triggered.
• A Stop-Loss order is designed to prevent further losses on the existing position once the stock reaches a specified price and is filled as a market order.

Note: It is possible that a Stop-Loss order may be filled at a price much different from the pre-determined price, especially in a volatile market.

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How to trade with Take-Profit/Stop-Loss orders

Determine your risk/reward ratio

The risk/reward ratio (r/r) compares how much a trader is willing to lose (risk) against how much they believe they could profit on a trade (reward). Investors use the r/r ratio to set the prices of Take-Profit/Stop-Loss orders, which can help them manage their risk of losing money on trades.

So how can we determine an r/r ratio? Suppose a trader reviews their trading history with 60% of their losses and 40% profit. Assume they would like to stick to the same trade strategy in the future.

When they set the r/r ratio as 2/3 for an order, the order’s loss possibility rate (60%*2) is equal to its profit possibility rate (40%*3), which indicates the order is neither losing nor profitable.

If the r/r ratio is less than 2/3, such as 1/2, the order’s loss possibility rate (60%*1) is smaller than its profit possibility rate (40%*2), which illustrates the order will likely result in profit.

Conversely, if the r/r ratio is greater than 2/3, the order will lose money. In this case, the trader has the highest chance of success if they plan their r/r ratio to less than 2/3.

To sum up, an investor can decide the r/r ratio according to their personal historical profit/loss rate or the profit/loss ratio of the trading strategy they plan to use in order to ensure that the profit possibility rate of an order is greater than its loss possibility rate. This way, an investor’s overall profits may exceed his/her overall losses.

Set the prices for the order

When you have a long position to exit, or you want to enter a long position first, set Stop-Loss price < Cost basis/Buy price < Take-Profit price.

An investor’s r/r ratio is 1:2, and the cost basis or the buy price is USD20, and we presume the take-profit price could be USD21.20 with a profit of USD1.20 (a Take-Profit price can be determined by traders’ personal technical analysis. Here we are taking USD21.20 as an example). Seeing that the r/r ratio is 1:2, its loss should be half of USD1.20, which is USD0.60, and the stop-loss price could be USD19.40.

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When you have a short position to exit, or you want to enter a short position first, set Take-Profit price < Cost/Sell price < Stop-Loss price

If the risk/reward ratio is 1:8 and the cost or the sell price is USD20, an investor may set USD16 as the take-profit price, which means the profit is USD4 (a take-profit price can be determined by traders’ personal technical analysis, and here we just take USD16 as an example). To determine the loss, take USD4 divided by 8, which is USD0.50. This is a loss that the investor can handle. Therefore, its corresponding stop-loss price should be USD19.50.

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How to set up a Take-Profit/Stop-Loss order

Swing traders can use Take-Profit/Stop-Loss Orders in the following three scenarios:

• when you have a position to exit,
• when you want to enter a long position first
• when you want to enter a short position first with a margin account.

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The Bottom Line

Placing Take-Profit/Stop-Loss orders as an exit strategy may be a practical way to manage your open positions. Be sure to work out the r/r ratio before entering the market. A target price should be set in both Take-Profit Orders and Stop-Loss Orders.

When one of them is filled, the other is automatically cancelled.

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