The importance and risks of advanced trading order types

In volatile markets, advanced trading order types can be very useful in limiting potential losses. There are, however, some things to consider when using these.

Stop Orders

The foundation for most advanced order types is the Stop (Loss) order. As the name implies, this order is typically used to limit losses or lock in profits. It involves defining a trigger price, at which a market or limit order is activated. The latter case is also referred to as a Stop Limit order. For example, if a Bitcoin is bought at $600 and a Stop Loss order is set at $500, this means the Bitcoin will be sold for the best available price as soon as the exchange rate touches $500. Likewise, this order type can be used to buy a Bitcoin at the best available price when the exchange rate touches $500. This is thus a powerful tool to manage positions without having to actively monitor them.

Setting the trigger price

When using Stop orders, the most difficult question is usually at what level the trigger price should be set. There are various techniques to determine the optimal point, but there are some things to keep in mind. Cryptocurrencies are one of the most volatile investments. The daily volatility, measured as one standard deviation, of Bitcoin in 2014 so far is 4.74% (based on BTC-e data). This means that 32% of all daily movements are expected to be more than 4.74% or less than -4.74%. When the goal is to limit losses, there is a 16% (one sided) chance of an adverse movement of more than one standard deviation. Simply said, you expect a loss of more than 4.74% every 6.25 days, or roughly once a week. In the case of Dogecoin this is even 8.96% (using data from Cryptsy since February 1, 2014), although this is for a part due to the 1.6 wallet update.

As this is just the daily volatility, a multi-day value could be calculated by multiplying with the square root of time. To get the 10-day volatility, the given numbers are simply multiplied with the square root of ten. This would result in 15% for Bitcoin and 28% for Dogecoin. These values show why Stop orders can be a useful tool, but also that the trigger price shouldn’t be set too close to the current price. In the latter case they could be triggered sooner than intended.

Gap risks

Lastly, it should be noted that Stop orders never guarantee a certain price. They can be used as a tool to limit losses, but certain events can always lead to big jumps in price. If a Stop Loss order is set at $500 and the price jumps from $501 to $470, then a market order will be activated and sell at a considerably lower price than anticipated.

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