The ultimate purpose of a stop loss is (as the name suggests) to limit losses in the case the market moves against your position, however there are downsides to using stop losses which aren’t always obvious.
In this article, we will look at why stop losses don’t always keep you safe (or at least as safe as you think), and examine an innovative alternative way to protect your crypto from market crashes.
What is a stop loss, and why are they used?
A stop loss is defined as an order placed on an exchange which triggers when a certain price is reached. Stop losses are used by both long buyers and short sellers to limit losses when the market heads in the opposite direction to where they want it to go.
In the case of a long position, this is likely to be a sell order if the price falls to a certain level, and the inverse is true for short sellers.
Types of Stop Losses
There are a couple of different ways to use Stop Losses, and some slightly different terminology to understand.
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Firstly a basic stop loss, often referred to as a Stop-Quote, triggers when an asset drops below a certain level.
Regardless of price, it then attempts to sell the asset immediately. However, if there is no buyer at this price, this can push the execution price down even further, meaning your stop loss doesn’t always execute at the price you set.
Stop Limit Orders
Secondly, a Stop Limit order triggers only at a certain price when a threshold is triggered.
However, the danger here occurs if there is no buyer, then you can end up with a sell order at a price higher than current price, and not get your position filled.
Thus, if you’re not paying attention, you can end up finding yourself riding the price down with the market, but your asset ends up getting sold when it’s on its way back up again.
This is pretty much the crypto traders version of getting a double kicking whilst you’re already down…
Trailing Stop Loss
Some traders use trailing stop losses, which are often used when the market is heading in the right direction. This means as the market continues to pump higher, the stop loss keeps moving upwards, keeping a roughly similar gap.The theory of using a trailing stop loss is to ensure that profits are locked in, and that flash crashes and market reversals do not wipe out already earned gains.
However, markets oscillate, and rather than moving straight up, there is normally some pullback before an asset continues to appreciate in price.Therefore, a trailing stop loss can cause the stop to be triggered due to a pullback even whilst it’s still trending upwards. As markets oscillate, the chances of you missing further upside gains whilst using a trailing stop loss are actually quite high.
Unintended side effects of using a stop loss
Whilst it’s not all doom and gloom for the humble stop loss, and it’s fair to say that many traders use them wisely and make great profits, there are some unintended side effects of using stop losses.
Selling lower than now
If you set a stop loss, you are effectively choosing not to sell your crypto assets at the current price. Instead you’ve decided to sell it at a lower value.
This by definition means any expected return on the initial investment of the asset will always be lower than it is now.Of course, you can always use a take profit order and then just leave it open on the order book. Assuming the asset has some price action, one or the other will eventually be triggered, but it’s a complete coin toss as to which it will be.
Getting picked off by bots
A stop loss order appears on the order book, giving information about levels to other traders. These can (and, in all likelihood, will) be picked off by algorithmic high frequency trading bots.
Every time a stop loss is triggered, you generally end up being charged a fee for trading. Therefore, setting stop losses frequently can have the unintended effect of eating up your capital as these fees are applied, and, whilst they may individually be quite small, fees soon add up, and this creates a situation akin to a form of parasitic slippage.
Whilst some exchanges determine the trigger point on a stop order to be the last executed price, others use quotation prices (in other words, the highest bid or lowest ask price).
In a market with low liquidity, this can trigger a stop loss order at a significantly lower price than you expect it to be. It is always worth checking on an exchange to see exactly when a stop order would be triggered.
Missing the Rip
Of course, the worst unintended outcome is the market ripping to the moon right after your stop loss got triggered. It’s the crypto-traders version of Murphy’s law. Not only did you sell your crypto at a discount, but now it’s going to cost you a heck of a lot more to get back in.
Locked Up and nowhere to go
Setting a stop loss order means keeping your crypto on an exchange, and this means you cannot use your asset for staking, yield farming or any other purpose. Furthermore, many crypto exchanges are centralised, meaning you technically don’t have control of your private keys… Remember the golden rule: ‘Not your keys, not your crypto’.
Bumper's Stop Loss alternative
There is of course an alternative solution which preserves the upside while still providing you with protection from downside moves in the highly volatile crypto market.
The innovative architecture of the Bumper protocol allows users to take price protection, but negates concerns about whether a stop loss is a good idea or not.
It does this by allowing you to deposit crypto into the protocol’s smart contracts, and in return you are given a ‘Bumpered’ asset which represents the crypto you have locked up. The Bumpered asset has baked into it a protection floor which acts as a minimum value level for that asset. If your position closes and the price of your asset is under the floor, you get stablecoins to the floor value, but if the price is higher, you simply get your original token back (minus the premium of course).
What’s ingenious about Bumper’s mechanics is found in its pooled architecture. Because redemption into stablecoins (or the original deposited asset) only occurs after the position is closed, Bumper effectively solves for slippage, meaning the parasitic costs of fees for trading in and out of positions is eliminated.
Essentially, with Bumper, you don’t need to care too much which way the market goes, as you’re essentially protected from the downside, and you won’t miss out on the gains if the market moves higher.
Want to know more about how Bumper works?
Check out some of these useful documents to understand how Bumper protects your crypto from volatility: