Limiting losses can be crucial to consistency as a trader, and by extension, so is the use of stop-loss orders. But how can you determine where to place them? Read more.
Introduction
Trading in the financial markets requires that a trader become aware of and fully understand different “order types." An understanding of how an order type works can be significant; order types and names can differ between markets, jurisdictions, and the trading platform used to place the trades.
In this article, we will focus on one of the most important order types, the “stop-loss order." This order enables a trader to close an open position or exit a trade as a form of protection against adverse price moves .
The stop-loss order is a crucial tool that should be in the toolbox of every trader. A stop-loss order is a type of order that traders use in forex market trades to better manage their risk – it can be used to limit unrealized losses or to secure unrealized profits. A stop-loss order may also be used in an attempt to save a part of a trader’s floating profit or to reduce a floating loss by utilizing a trailing stop-loss order.
Using a stop-loss order in the forex market
Let’s look at an example of a stop-loss order with the GBP/USD currency pair:
Suppose you are long (meaning you bought) GBP/USD, which is currently trading at 1.2500, and you believe it has the potential to reach 1.2800. However, if your strategy didn’t work and GBP/USD weakened, you want to limit your losses and wish to exit the trade at 1.2200. A trader may place a stop-loss order to sell GBP/USD at 1.2200.
Similarly, suppose GBP/USD is trading at 1.25 and you’re short, meaning you sold GBP/USD. You believe GBP/USD will fall to 1.2200. However, in the event that GBP/USD moves higher, a trader may wish to limit their losses and place a stop-loss order at 1.2800.
In both cases, the stop-loss order attempts to exit your open position at a pre-set level if the market moves against you. Having a stop-loss order in place for any open position may help reduce the loss if the market moves in the opposite direction.
Stop-loss order methods
There are multiple methods that traders use to decide where a stop-loss order should be placed ; it depends on every trader's strategy and why they entered the trade to start with. It is also common among traders to know and decide how and where their stop-loss order will be placed even before opening the trade or entering the market.
Always keep in mind that a stop-loss order is not a guarantee of stopping losses. In extremely volatile markets or if there is scarce liquidity, it is possible that a stop order will not get triggered or executed at the trader’s specified price.
Placing stop-losses at a predetermined percentage value
A percentage-based stop loss uses a pre-set portion of the trader’s account or a percentage of a price move. For example, a trader might be willing to risk a percentage of their equity or a percentage of a price move.
Once the trader determines the percentage risk, they then use their position size to calculate how far the stop-loss should be set away from the entry point.
The disadvantage of the percentage method is that it forces the trader to set the stop-loss at an arbitrary price level, which could result in the trader getting stopped out of their trade early if the stop-loss is set too tight. If the stop is set too wide, this increases the amount of pips that need to move in your favor in order to make the trade worth the risk.
Placing stop-losses at support or resistance levels
As buyers and sellers continue bidding in financial markets and as prices continue to fluctuate between different prices, support and resistance levels develop over time. These levels are usually significant because historically, the market has found equilibrium between buyers and sellers at the same levels. The trader could set stops beyond these support or resistance levels, so that if these levels do break, a trader would realize that maybe the market sentiment has changed and the price may continue in the opposite direction.
Placing stop-losses at volatility pip values
If you have been trading GBP/USD and you notice that the pair has been moving about 100 pips each day, you can set your stops based on this daily or any timeframe volatility average. There are formulas for calculating “volatility stops," such as the Average True Range indicator (ATR).
Placing stop-losses at a predetermined time of day
A trader may utilize multiple ways to manage their time limit exits, including but not limited to manually closing their positions at a set time, utilizing pending or entry orders, or using a script to close all trades at a set time. It is important to remember that order types or names may vary between brokers, trading platforms, and regulatory jurisdictions.
Conclusion
Whatever stop-loss method you choose, it is always important to take into account multiple factors when deciding on a stop-loss: your risk management as well as the trading strategy itself, to name a few.
These orders are an important risk management tool for forex traders, as they limit potential gains or losses in case price action moves the wrong way.
Disclaimer
This article and its contents are intended for educational purposes only and should not be considered trading advice. Forex trading is high risk. Losses may exceed deposits.
