What Is A Stop Loss Order In Forex?

By Steven Hatzakis Thursday, January 18, 2018

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There are no definite rules to set stop loss order, but there are some strategies that you can consider applying to your trade. Let’s find out!

What Is a Stop Loss Order?

Stop loss order, also called “stop order” or “stop market order”, is one of the most complex terms in the Forex market to understand and put into practice. It is an order that cancels your current trading position when the amount you lost has reached the stop loss point that you set in the beginning. The stop loss order limits the loss that a trader has to carry and it is most used in a long position.

Why Should You Use Stop Loss Order?

In a Forex trade, it is advised that you place the stop close to the average daily price of the currency pair that you’re trading with. By doing this, your account will be protected even when the market moves abruptly by breaking the trend, forcing you to start the trade then turns into a loss.

The order protects your account by automatically closing down your trade when your loss has reached a specific amount. Keep in mind that this order exists in order to help traders end the trade as soon as possible when the market goes out of control, and there seems to be no chance of winning profits.
You may find it irritating when facing the reality that you have lost due to your faulty decision, so unless you want to bear greater losses, you should take advantage of the stop loss order and set the suitable amount before trading. Also if the market counters your trade, you should not move the stop any further to avoid losses since you would make the stop loss order useless without its protective purpose.

Example

If you want to hedge a vital decline for your own shares of EG Inc., which is trading $50 at the moment, you could set a stop loss order at $48 to sell your EG Inc. holdings. This is called a sell-stop order. The stop loss order will be executed once the trade falls below $48 and EG Inc. will sell at the next price such as $47.90.

Stop Loss Strategies

There are no definite rules to setting stops, but there are some strategies that you can consider applying to your trade.

Set Multiple Stop Losses

Forex traders often assume that the market may be manipulated by the market maker to exploit your stop and profit from it. To prevent this from happening, traders have set numerous stops close to the current trade price so that there will be no currencies that will bring down your entire trade.
However, most traders, in reality, do not make trades big enough to make significant changes even if their market makers were fine with it. To reaffirm, the Forex market has an average turnover of over $4 million. Occasionally, there are moments that you can set multiple stops.

Reverse Stop Losses

Stopping at a certain loss point then entering a new trade with the stop in the opposite direction is what the stop and reverse strategy are all about. This strategy requires experience and adequate knowledge, so it is not yet recommended for beginners and most brokers wouldn’t accept this kind of trade since once the first stop is carried out, you would need another order with a new stop in the opposite direction.

Trailing Stop Losses

A good way to gain profits and cut down your losses is using the trailing stop. By setting the stop trail behind the market price by a certain amount, the stop will move upward, in accordance with the increasing market price, when your trade is profitable. By doing this, the market would move in your favor and the loss you can take would remain the same. Even when the market goes against you, the trailing stop will protect you from getting your entire trade wiped since it has moved upward as your profit.
The following EURUSD chart shows a great example of trailing stop loss order:

Stop Loss Order Gapping

Let’s say EG closes at $48.50 and opens at $44.90 the following day, your stop loss would be executed and your shares sell at the next available price, $45 for example. When this happens, the stop loss order did not go along as planned and you lost 10% instead of the 4% you had expected when placing the order.

Many experienced traders use stop limit orders instead of the stop loss order since price gapping is risky while using stop loss orders. Stop limit orders, unlike the stop loss order, are orders that allow traders to sell at a certain price range. Although this type of stop does not return much profit, it reduces more significant risks than the stop market order in long positions.

Although price gapping is lessened in a 24-hour market like Forex, traders still need to be aware that prices can still go under or higher than stop-loss orders because of its inconsistency, or little liquidity.
Besides the strategies that you can apply to stop loss orders, here are types of stop-loss that is available in the Forex market.

Best Ways to Set Your Stop Loss Orders

Setting Stop Loss Orders Based on Percentage

Setting stops in accordance to the percentile of a trader’s account is the most basic type of stop. Obviously, the percentage risk will be different for different traders with different trade sizes. Aggressive traders might be able to risk up to 10% of his or her account while others often hold less than 1% risk on each trade.

Traders can calculate how far from the entry they should place a stop based on their trading position size after the percentage risk is settled. By doing this, traders can set stops effectively with his or her account.

However, this is an inaccurate method of setting stop because you should set stops on your trade in accordance with the market environment or the system’s regulations instead of setting them based on how much you can afford to lose.

Although it manages risks, you may be missing out a lot of profits that may come in the Forex market. Let’s say a trader with a minimum trade of 10,000 units owns a mini account and $500. With a stable interest rate of  1.5620, he decides to trade with the GBP/USD pair. In this case, he is risking no more than 2% of his account, which is $10 with each pip equivalent to $1. The maximum stop he can set is 10 pips away from the entry, which is why he puts it at 1.5630 as follow:
 
However, the GBP/USD pair can move up to 100 pips each day, and the trader could be effortlessly stopped out at any movement that this currency pair makes. Now that the trader has been stopped out, not only did he lose the trade, but he also missed out on the opportunity of profiting 100 pips.

In sum, you should notice that the percentage-based stop loss order forces the traders to place stops at random price levels. The stop might be placed too close to the entry just like in the example above or placed unreasonably without technical analysis. In this case, the trader would want to look for an adequate broker that is competent and suitable for his or her trading style and capital that enables him or her to trade with micro or custom lots.

For the trader to avoid great risk, before losing 2% of his or her account, he or she should put a stop 100 pips away on GBP/USD  with 1k units (100 pips x $0.10 = $10).

Setting a Stop Loss Based on Price Volatility

The amount that a market can likely move within a specific amount of time is called volatility.
You can use the Average True Range (ATR) to find out the volatility of a market as follow:
The skill of predicting and calculating the amount that a currency pair usually moves can support you in placing stop losses and prevent your account from being wiped out due to sudden fluctuations in price levels.

Knowing that the USD/JPY moves 50 pips a day, for example, setting a stop at 10 pips will most likely get you stopped out too early with just a small movement in the market. Therefore, figuring out the market volatility may give you insight into the right direction and give you chances to win more profits.

Setting a Stop Loss Based on Time Limit

By choosing a specific time to place a stop, you are using time stop on a trade. In the Forex market, it could be set at any time of the day during its work hours, which is 24/7. If you don’t feel like holding the trade overnight, you are allowed to set a stop at 4 p.m. for example when you’re done for the day.

Mistakes Traders Make While Placing Stops

Without careful consideration and risk management, placing stops could result in more losses than profits.

Setting Tight Stops

One of the most common mistakes is placing stops too close to your entry point without taking the market volatility into account. You would then get stopped out too soon in the end and miss out on a lot of profits.

Using Position Size to Determine the Number of Pips as a Basis for Stops

Although your position size is important, it is also crucial to take the market environment into account. That’s why it’s important to decide on where to place your stop first before calculating your position size.

Placing Stops Too Far

Some traders tend to place stops as far as possible and wait for the price to come in their favor. This would defeat the purpose of stops since placing the stop too far will make the number of pips that your trade needs to make the trade worthwhile increase. There’s no point in keeping a trade that keeps losing when you can use that amount to invest in another trade that is more profitable.

It is recommended that you set stops closer to the entry point than the profit goal. This way, your risk would most likely lessen, and there would be more rewarding profits.

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