It is an emergency instruction to your broker, telling them to exit a trade when it reaches a specified price. The purpose of a forex stop loss is to reduce a trader’s losses if the market changes in an unfavourable direction. This is especially important if you are using a forex robot or another automated trading method, since these strategies do not involve the responsive monitoring or intervention associated with manual trading. While stop-loss orders are commonly associated with long positions, they are also regularly applied for short positions in forex trading. This article will explore the different types of stop loss, why they are important and the pros and cons of using them in forex trading.
Why Setting a Stop Loss Is Important
When placing a trade, considering the price at which you wish to exit and placing a corresponding stop order is good practice. As a trader, protecting your capital from the cumulative impacts of small losses is crucial to maintaining an active trading account. Regardless of your level of experience in forex trading, the market is so volatile that it is impossible to predict future movements with any certainty. Unforeseen economic shocks, evolving political situations and even rumours of the aforementioned instability within the financial services sector can have significant repercussions on currency prices, and will impact the forex trading market. Even if traders follow global developments very closely, it is still not possible to place a risk-free trade. There is always the possibility that the market may move unexpectedly against your position. Every trade placed involves a proportion of risk. To protect against this volatility, many traders implement a stop-loss order on their trades. This stop-loss order protects them against being wiped out by large losses. Setting this stop-loss protection is even more important when trading using leverage, as leverage can increase profits but also amplify losses. The smaller your margin requirement and the more leverage you are intending to use, the greater the risk to your capital. Stop losses should be set carefully, as the price at which you exit your trade is a vital part of the forex trading strategy. Your stop loss will protect you against significant loss, but it may also hamper profit if it is set at the wrong point. Forex trading is sometimes a game of chance as much as skill, but practice will improve your reading of the market. The more experience you acquire in forex trading, the easier it will be to choose where to set your stop losses across sessions. Setting a stop-loss order also protects against the emotions that may cloud your decisions when trading in forex, as you have already set a considered and immovable safety net for your trade.
Types of Stop Loss
There are many types of stop orders that can be used in forex trading to protect traders against potential losses. Stop-loss market orders and stop-loss limit orders are discussed below.
1. Stop-Loss Market Orders
When arranging a stop-loss market order, you first set your stop-loss price. When the market nears your set limit, a market order is automatically issued by your broker to close your position at the current price – whatever this may be. It is worth noting that stop-loss market orders differ from conventional market orders. With a standard market order, a trader outlines that they wish to trade a certain number of shares of a stock at the current market-clearing price. Basic market orders do not allow traders to set an exit price. Using a stop-loss market order instead allows the investor to specify their limit price. In most cases, the stop-loss market order will reach or end up very close to the stop loss price set by the trader. In extremely volatile market conditions, however, you may find that the exit point is different from the stop-loss price that was set by the order. This scenario is referred to as slippage. If your trading activities are affected by slippage, you may find that you end up selling securities at a lower price than you had hoped. Slippage is one of the downsides of trading using a stop-loss market order. Consequently, some forex traders prefer to exit trades manually, so that they can retain control over assessing the market conditions for each trade, and exit when they deem conditions to be favourable. If a stop-loss market order has been set, it will automatically exit the trade regardless of conditions.
2. Stop-Loss Limit Orders
A stop-loss order, described above, triggers when a security falls to a certain price – it is a market order that executes at the next price available. If this price is lower than expected, the trader may lose money due to the slippage. Traders using limit orders specify the minimum or maximum price at which they wish to buy or sell. With a stop-loss limit order, once the price of the security arrives at the specified stop-loss price, a limit order is immediately generated by the broker to end the position, either at the stop-loss price or a better one. In contrast with market orders (which are set up to close the position either at or past the stop loss limit), the limit order will only close when the price reaches the stop loss limit or a better price. This ensures that your trade is not executed at a lower price than anticipated, preventing potential losses from slippage. Limit orders are, however, more expensive and have time frames. This means they may expire before they are executed if the security price never reaches its set limit. Stop-loss limit orders also introduce a new problem, since they don’t automatically exit the trade when the price goes strongly against your position. If the price drops continually without your order being filled, your loss will continue to grow and the stop loss imposed will be negated. A trader with a ‘long position’ – someone who has bought currency in the expectation that the value will increase – may wish to specify a limit order above the current market price to maximise profits. They could then set a market order below the market price to help minimise any losses on the position. A trader with a ‘short position’ – someone who chooses to sell a security with the view to purchasing it again at a lower price in the future – may choose to set a limit order below the current price alongside a market order over the current price to mitigate risks.
Stop-Loss Strategies
Volatility Stop
Volatility describes the potential fluctuations within a market during a specific timeframe. When prices change very quickly, the market can be described as volatile. A volatility stop applies a methodology based around market volatility. If volatility is high, traders employ larger stop losses to allow for greater market swings. If it is low, the stop loss used can be more conservative. Correspondingly, in times of high market volatility, a trader should set wider targets to capture large price swings. With low volatility, profit should be set closer to the entry price. Getting to know how much your chosen currency pair moves enables you to set the appropriate stop-loss levels. In turn, this helps to prevent exiting a trade early based on random and temporary price fluctuations. For example, if GBP/USD has moved approximately 150 pips per day during the last month, setting a stop loss at 30 pips means that you will likely exit the trade too early if there is a slight fluctuation in the price. Once the percentage risk has been determined, a trader uses their position size to calculate how far the stop should be set away from the entry. The percentage is set at trader discretion. More confident traders may risk up to 10%, while cautious traders might set their percentage-based stop loss at 1% of their capital. The main problem with using a percentage-based stop loss is that it is based on how much you are willing to lose, rather than the market conditions of your chosen currency pair. This means that it forces traders to place their stops at arbitrary price levels, which can lead to ineffective trades that fail to reach their profit potential. To maximise potential, stop losses should always be determined according to the market environment or system rules, not based on how much you do/don’t want to lose.
Chart-Based Stop
This type of stop loss considers the different market signals, indicators and patterns that can be observed within the forex market. Using forex charts, traders use trend lines to observe and interpret areas of resistance and support in price action. Stops are set beyond these levels of support and resistance as, if the market trades beyond these areas, it is deemed likely that other traders will play the break and push the market against your position. If the support and resistance levels are broken, unexpected market movements are increasingly likely. Setting your stops based on forex charts takes a high level of chart literacy and understanding. If this is your risk-management strategy, it is important that you are adept at reading and interpreting the charts to ensure your stop loss is set at the correct point.
Pros and Cons of Stop-Loss Orders
Using a stop-loss order is particularly recommended if you are trading using leverage, to protect against the extra losses leverage trading can incur. A stop-loss strategy that is based around the market environment is recommended. The market is a dynamic environment and, to be efficient and productive, your stop-loss strategy should take detailed account of the trends that are currently occurring. As with many forex strategies, gaining experience using stop losses will help to improve your limit setting. Trading conservatively with cautious stop losses to begin with will help to conserve your capital and give the greatest chance of accruing profits in the long term. WikiJob does not provide tax, investment or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.
