Understanding how to stop losses effectively is a fundamental part of any financial spread betting strategy (read more). But what is this thing called a 'stop loss'? On the face of it, suggesting that we specify that we would sell out of our bet at less than the current market price sounds counter intuitive. Why on earth would we want to make that loss?

To find the answer to that, we need to look at our overall risk strategy for financial spread betting. Risk strategy is our overall approach to how we mitigate the potential for loss within our overall trading strategy. In my earlier article 'Establishing a financial spread betting strategy' we looked at why our overall approach would be to limit our losses and maximise our gains. Sounds simple, right?

If we were only running one or two open bets, and we had time to monitor their positions in real time, we might be quite happy to keep manual control over the entire buy/sell piece. But in reality we may have any number of spread bets open at any time, and most of us have other things to do (ie a life!) other than sit staring at a screen all day. Furthermore, we want to try and take as much emotion out of the whole thing as possible, which means we want to try and automate it.

This is where the 'stop loss' is so vital. Most decent accounts these days offer the facility and it gives you the opportunity to start to limit your downside risk. You can set a lower price at which the system will sell you out should the market reach it. So if a you are in a bet at 100p with a £10 per point price, you may want to limit your total risk to no more than £200. In this event you set your stop loss at 80p. Should the market drift down to 50p whilst your bet is still open, the system will close your position automatically at 80p. It will incur a loss of £200, but that's better than losing the £500 you would have done if you hadn't been closed out.

Don't forget that a normal 'stop loss' is only a trigger point for your account to try and get out of that open position. Remember there is always the possibility that the market will move further away from your position by the time it is possible to execute the trade. If your bet is at 100p and you set a stop loss at 80p, it is conceivable that market news could come out that almost instantaneously moves the price down to 50p, before the system can close your bet at 80p. This is called market slippage. The only way to avoid exposure to this is to use a 'guaranteed stop loss'. This is where the financial spread betting company guarantees that you will be closed at your price. They simply take the loss themselves. Naturally, they take a small premium from all 'guaranteed stop loss' positions to make up for this additional risk they take.

So, understand this, the use of stop losses is absolutely central to your success in financial spread betting. Get your head around it now, and you will have taken a huge step forward towards becoming a successful trader.