What is a Stop-Loss in Forex Trading?
Everyone wants to keep their winnings and halt their losing streaks in forex trading. Although no forex trader wants to lose money, it is advisable to limit losses and lower risk exposure because losing transactions are inevitable in trading.
For new traders in particular, a stop-loss order is a useful tool for stopping losses. In other words, a stop-loss order type is one that is utilised in forex trading to cap losses on a deal. ‘Stop order’ and ‘stop-market order’ are other names for it.
Stop-loss orders, as the name implies, are a sort of pending order that allows the trader to specify a specified level on the price chart that closes a losing position. In other words, it assures that the position is closed with the least amount of loss possible. The abbreviation for stop-loss is (S/L).
The order will result in a trade being closed at a loss. It is a trader’s order to their trading company or broker to execute a deal when the market price is at a certain price level that is lower than the trader’s entry price.
It is critical to understand that a stop-loss order is a sort of order known as a ‘stop order’. A stop order behaves differently from other order types, such as a limit order, which is utilised in a take profit order. A stop-loss order executes at the next best available market price after the stop order is triggered, where limit orders execute at the limit-price or better.
How does a stop order work?
It can be explained through the following examples:
Assume you purchase EUR/USD at 1.4110 with a stop loss at 1.4100. If no one is ready to accept your sell trade at 1.4100, your stop will not be activated at that price. It will be activated at the next market price at the end of the price cap.
Another example is when a trader opens a buy position at 1.5980 with the expectation that prices will rise. He is aware that the market is volatile and that it may move in the opposite direction of his expectations. So, before entering the market, he calculates the risk and places a stop-loss order below the entry price. If the bid price reaches the predetermined stop-loss price of 1.5880, the position is closed with a minimum loss.
Similarly, if a trader opens a sell (short) position expecting prices to fall, he would put a protective stop-loss order above the entry price in case prices spike up. If the ask price reaches the predefined stop-loss price, the trade is closed with a minimum loss.
Stop-loss orders in forex trading are intended to protect your capital by ensuring a minimal loss. It is a predetermined level set by the trader based on how much he or she is willing to risk and/or lose.
Why Would You Use a Stop-loss Order?
The forex currency market may be extremely volatile, and even minor losses can soon add up. Stop-loss orders are essential for protecting your capital, especially when trading with leverage, which can magnify any losses.
Before buying a currency pair, the top forex traders will plan where they will sell it if the trade goes wrong. They also know where they would purchase it back at a loss if they went short on a currency pair.
Using a stop-loss is just an automated means of ensuring that you quit the trade as intended. The same may be said for ‘take profit’ limit orders, which ensure that you exit a profitable transaction on time.
The main advantage of a stop-loss is knowing that you have an order ready to cut your losses without having to follow the market movement all day. This is especially beneficial for part-time traders, which is how most novice traders begin.
To set up a stop loss in forex trading
One of the most typical inquiries from new traders is how to place a stop-loss order when trading. Risk management and position sizing determine the size of your stop loss. Here is a step-by-step procedure for determining the appropriate stop loss technique for any trading system:
- Determine what price would indicate that your trade concept is incorrect and set the stop-loss (SL) order here.
- Set the take profit order (TP) at the price level where the market could move if you are correct.
- Choose an entrance price that ensures the reward of reaching the TP level outweighs the risk of reaching the SL. A 2:1 risk to reward ratio is frequently mentioned in trading books.
- The number of pips at stake is the difference between your entry and stop-loss levels.
- Choose a trade size that allows you to risk no more than 2% of your account on the trade. If you have $500 to risk and a stop loss of 50 pips, you can place a trade for 5 lots.
It is quite possible to use a very simple stop-loss system like using a 10 pip stop loss for every trade. However, this makes the trade less able to adjust trading parameters according to volatility.
Setting a stop-loss (S/L) will:
- Allow you to take a break. You can now take a break from trading knowing that your potential losses are limited.
- Remove the emotion from the trade, and you’ll be safe against the temptation to hold the position for too long or to close it too soon.
- Reduce risk which entails that quitting the deal when your limit is reached can save you from suffering substantial losses if the market makes a large move against you.
The importance of a stop-loss order in forex
A common argument against stop-losses is that they force you to exit a trade too soon. New traders will recount an experience of seeing a price drop 2 pips past their stop loss and then reversing back to whether they would have taken profits. Clearly, this is a frustrating experience – but there are also better alternatives to not using a stop-loss order.
It is possible that the issue is where you place the stop-loss rather than using the stop-loss. Narrowly missing out is easily worth the risk of suffering a lot larger loss if the market does not rapidly reverse from near your stop-price.
You can also close down your position in sections utilising an average method stop-loss, which means that some of your position can remain open to take benefit if the trend quickly turns.
Three good rules for setting up forex stop losses:
- Follow your stop. This entails using a ‘Trailing Stop’ to allow it to advance in the direction of a winning trade. If you add to your open position, it locks in earnings and helps you control risk.
- Never make your halt wider. This is equivalent to not having a stop at all; it will simply increase your risk and the amount you may lose.
- Don’t let emotions drive you to move a stop-loss. Any modifications should be made prior to placing your trade.
Is it a good idea to use a stop-loss?
Simply put, using a stop-loss ensures that you exit the trade as intended in an automated manner. ‘Take profit’ limit orders, which ensure that you exit a winning trade as intended, can be justified by the same logic.
The top forex traders plan where they would sell a currency pair if they lose a trade before they buy it. They also understand where they would have to purchase it back at a loss if they had gone short on a currency pair.
The main advantage of a stop-loss is the knowledge that you have an order waiting to stop your losses without having to constantly watch the market movement. This is especially beneficial for part-time traders, which is typically how novice traders begin.
It is entirely feasible to utilise a stop loss strategy that is quite basic, such as using a 10 pip stop loss for each trade. Nevertheless, this limits the trade’s ability to change trading parameters in response to volatility.
What is Stop Limit Orders?
Similar to a standard stop order, a stop-limit order has an additional stipulation. The investor selects both a stop price and a stop limit price when using a stop limit. Instead of a market order, which would be triggered by a conventional stop order, a limit order would be triggered if the securities in issue reached the stop price. When the trigger price is reached and the limit price can be reached, the deal will only go through.
Consider an investor who owns 100 shares of a company and has placed a sell stop order with a $50 stop price and a $48.50 stop limit price. The 100 shares of the said company will be sold if the stock drops below the $50 stop price as long as a minimum price of $48.50 can be attained. The 100 shares of the company will not be sold if the stock price has fallen significantly and a sell order cannot be fulfilled at $48.50 or above.
Pros and Cons of stop-loss
Offer some control over when a purchase or sale of a security is triggered
Guarantee execution as long as the top price is reached and you can execute the trade before the market close
Limit losses if the price of a security moves against an investor’s position
A stock may gap lover or higher at the market opening following company developments
Can be triggered by short-term price fluctuations
Might be executed at a price that is less favourable than the specified stop price
The most typical use for a stop order is to provide a means for investors to limit their losses on a particular position. A stop order is only executed when the price of the underlying securities reaches the price that was specified as the stop price. A secondary use for stop orders is that some traders will occasionally choose to use them to enter new positions.