What Are Stop-Loss & Take-Profit Levels?
Stop-loss (SL) and take-profit (TP) levels are two technical analysis concepts that help traders manage risk and lock in returns. Keep reading to learn why stop-loss and take-profit levels should be a part of your trading strategy.
What are Stop-Loss and Take-Profit in Trading?
Stop-loss (SL) and take-profit (TP) are price levels calculated by means of technical analysis (TA) that aim to designate goals for optimal position closing. Stop-loss and take-profit levels are commonly used when setting up stop-loss and take-profit orders.
Stop-loss and take-profit orders are two types of stop orders, which is a general term used to describe an exchange operation with a pre-established activation point in terms of price. Stop orders help traders limit losses and lock in profits on positions without daily (or hourly) monitoring of the market. Learn about all types of stop orders in this article.
A stop-loss order closes a position once a designated level of loss is reached, while a take-profit order closes a position once a preset level of profit is achieved.
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What is Stop-Loss Level?
A stop-loss is a price level at which a trade is closed to minimize an investor's loss on a position in an adverse market movement.
A stop-loss level is set below the current market price for long positions and above the current market price for short positions.
What is a Take-Profit Level?
A take-profit is a price level at which a trade is closed to maximize a trader’s profits on a position in a favorable market tendency.
A take-profit level is set above the current market value for long positions and below the current market value for short positions.
How to Calculate Stop-Loss and Take-Profit Levels
There are a number of techniques in technical analysis that help traders determine optimal stop-loss and take-profit levels. However, it is crucial to keep in mind that no TA method can guarantee a specific outcome or profit.
Support and Resistance levels
Support and resistance refer to price levels on financial charts at which the prevailing price trend is expected to pause or move the opposite direction. A support level occurs when a downtrend is likely to pause or reverse due to a concentration of demand, while resistance occurs at a price level where an uptrend is expected to pause or reverse due to a concentration of supply.
When using support and resistance levels to set stop-loss and take-profit targets, traders usually stick to the following guidelines:
- For long positions, take-profit levels are set several ticks above resistance, and stop-loss levels are positioned several ticks below support.
- For short positions, take-profit levels are set several ticks below resistance and stop-loss levels are positioned several ticks above support.
One of the most common ways to locate support and resistance levels is to use the Fibonacci retracements technical indicator.
A detailed overview of the concept of support and resistance can be found here.
Moving average (MA) is a technical indicator that works by smoothing out the price action and plotting a continuously updated average price. For long positions, stop-loss is commonly placed several ticks below a longer-term MA (for instance, 50, 100, or 200 daily moving averages), while for short positions, it is positioned several ticks above a longer-term MA.
If you are interested in more details about MA and other popular trading indicators, check out this article.
Many traders set stop-loss and take-profit orders in accordance with the risk-to-reward ratio they choose to adhere to. A risk-to-reward ratio (or R/R) is a metric that measures a trade’s potential returns against its potential losses. R/R is calculated by the following formula:
risk-to-reward ratio = (entry price - stop-loss price) / (take-profit price - entry price)
While the acceptable R/R ratio can vary, trade advisers often recommend using a ratio not much higher than 2:1.
Some other indicators in technical analysis that traders frequently use to determine stop-loss and take-profit levels include: Bollinger bands, Relative Strength indicator (RSI), and Moving average convergence divergence (MACD).
Why use Stop-Loss and Take-Profit Levels?
Setting up take-profit and stop-loss orders can help protect a trader’s portfolio from excessive losses and optimize returns. This is a free, accessible, and easy-to-implement way to insulate your decision-making from emotional influences and protect your capital from sharp market turns.
What are stop-loss (SL) and take-profit (TP) levels?
A take-profit is a price level at which a position gets closed in order to maximize profits in a favorable market movement, while a stop-loss is a price level at which a position gets closed in order to minimize losses in an unfavorable market tendency.
Why use stop-loss (SL) and take-profit (TP) orders?
Setting stop-loss and take-profit orders allows traders to manage risk and magnify profits.
How to calculate stop-loss and take profit levels?
There are several approaches to calculating stop-loss and take-profit levels. Here are a few:
- Using long-term Moving Average as a reference
- Using support and resistance levels as a reference
- Calculating stop-loss and take-profit levels using the risk-to-reward ratio formula
Is setting stop-loss and taking profit levels necessary?
Stop-loss and take-profit levels help keep emotional trading at bay and can protect traders against sharp market moves.