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HOW TO USE STOP LOSS ORDERS IN FOREX TRADING
Forex and CFDs trading often comes with a high risk of losing money for various reasons. One of them is because investors fail to use stop-loss orders which set the floor for their position in forex to stop their trades from losses.
This concept plays an important role in trading any financial instruments. However, understanding how a stop-loss order works can not suffice to help traders determine where they should place a stop-loss level. Any improper stop-loss placements can result in bigger losses. This article will partially answer the question of how to use this order in forex.
What is a Stop Loss?
The Definition of Stop Loss
Simply, a stop-loss order is an automatic buying or selling order that you place to limit unexpected losses when the value of currency pairs goes against your trades – in other words, goes in an unprofitable direction. This function is available on trading platforms (e.g. MetaTrader 4 and MetaTrader 5) which can be customised by a broker. Setting a specific number of pips or dollars away from the entry value means you are willing to risk that amount.
For example, a forex trader enters a position of trading EUR/USD at the price of 1.4585 and he wants to risk no more than 10 pips (equivalent to 0.0010). Then he places his stop loss at 10 pips below the entry point at 1.4575.
(Source: Mark Heitkoetter, “The Complete Guide to Day Trading)
This calculation is very simple to all forex trading beginners. If investors do not use stop losses in trading, they will end up wiping out their account balance in a short time as no one can predict exactly how prices will move in the future. Besides, their immediate decisions of exiting intraday trades render forex day traders and scalpers confronted by the higher risk of losing money, so this function is applied more often in short-term trades and long-term ones.
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So how does the stop-loss order work? Generally, if the price of a currency pair reaches the stop-loss level, the order will be executed and the position will be automatically closed. Stop-loss orders are often placed with a pending order (e.g. Take Profit, Buy Stop or Sell Stop). When investors open long positions, they always set the order below the current Bid price, whilst the order is placed above the Ask price in short positions.
The given example is regarding a long position when forex traders expect the euro value to increase, yet fear that the price in the real-time market goes down. So they have to put a stop-loss order below the current price to avoid losses. In case investors short the euro and expect its value will depreciate in the future so that they can buy it back at a lower price, the stop-loss order will be placed above the current sell price.
Types of Stop Loss Orders
There are different kinds of stop-loss orders that investors can apply to their trading:
Stop-Loss Limit and Stop-Loss Market
Stop-loss market orders, or also called stop-market orders, is a type of a stop-loss order, performing the same functions as normal stop-loss orders mentioned in the next part. Accordingly, when investors apply a stop-loss order into their trades, it also means they are using a stop-market order. This order will execute as a standard market order when a currency pair’s value reaches a designated stop price or worse.
Despite aiming at protecting traders against further losses, stop-market orders can increase the possibility of losing more money than anticipated when no one is willing to trade at your specified stop level.
Just imagine that you open a long position of trading USD/JPY at 105.947 and expect the price to increase to 106.000. You then decide to risk only 10 pips and place a stop loss of 105.937. Unfortunately, the price witnesses a drop to 105.930 (thus, activating your stop-loss) before recovering and reaching 106.000 eventually. As a result of setting a too close stop-loss, you fail to trade the currency pair at the desired price. The case study proves that determining the too tight distance and ignoring volatility can make you get out of the trade too quickly, instead of protecting your trades from loss.
Another type of stop-loss orders is a stop-loss limit order that functions as both stop and limit orders. Thus it uses two stop and limit prices respectively. When the market reaches the predetermined stop price, the order will trigger at that price or better.
Normal Stop-Loss and Guaranteed Stop-Loss
Depending on whether a broker can ensure to close positions of traders at their predetermined price, the broker will provide ordinary stop-loss orders and guaranteed stop-loss orders.
A default stop-loss order in two MetaTrader 4 and 5 platforms is a normal (standard or ordinary) order and offered free of charge. When the order triggers, traders will automatically exit their trades at the best available price in the market. However, when the stop-loss order is implemented, it will become a market order and trigger slippage, especially during a period of high market volatility. Usually, a negative slippage can make traders lose more than they expected.
For example, you plan to trade GBP/USD at 1.23318 and set a stop-loss level at 1.23308. If the value afterwards falls to 1.23295, your stop-loss order will be executed at 1.23295 – not at 1.23308 as requested because the slippage which is the difference between 1.23308 and 1.23295 (equivalent to 13 pips) takes place.
Meanwhile, when it comes to guaranteed stop-loss orders (GSLO), customised trading platforms of several brokers can provide GSLOs to protect your positions from market gapping or slippage by ensuring to exit your trades at the precise level you specified, no matter how volatile the market is. That is why GSLOs often charge traders but only when the order is executed.
After installing the trading platform of a broker on PCs or mobile phones, you will click the stop-loss button and add a GSLO to your orders. A GSLO should be set at a minimum distance away from the entry point.
Static Stop-Loss and Trailing Stop-Loss
A static stop is the simplest form of a stop-loss order. Accordingly, traders will place the order at a static price which remains unchanged until their trades reach the stop or limit level (equivalent to the lowest or highest value placed). Forex investors often use a wide range of such technical indicators as Average true Range or Bollinger Bands to set static stops. This stop-loss order sounds safe and suits those who are looking at the minimum 1:1 risk-to-reward ratio.
On the other hand, a trailing stop is a stop that can be adjustable when prices of financial instruments move favourably. The size of the trailing stop is calculated by a determined percentage or number of pips away from a currency pair’s current value.
To illustrate, a forex trader opens a long position of trading the AUD/USD currency pair at 0.71301, with a 50-pip stop at 0.71251 and a 100-pip limit at 0.71401. Once a trade moves up to 0.71320, the investor can adjust their stop to 0.71270. The trailing stop level can move up to the entry value of 0.71301 which is also seen as a breakeven price.
The picture above describes precisely how trailing stop-loss orders work. In reality, such orders can only move in one specified direction to minimise losses or lock in profits. This means that if trailing stops move up, they cannot bounce back down.
Likewise to a normal stop-loss order, trailing stops should be placed at a proper level. Because trailing stops are triggered by the market price movement, too small trailing stop levels will result in no room for trades to move and even lead to losing trades. Meanwhile, too large levels cannot protect your gains significantly.
Setting a trailing stop order in MetaTrader 5 (Source: MetaTrader 5)
A trailing stop order can be easily placed in the MetaTrader 4 or 5 by right-clicking on your open trade and selecting the expected value of the distance between the current market price and the stop-loss level. There are some available options for the stop-loss size; otherwise, you can write up a customised stop level.
How to Use Stop-Loss Orders in Forex Trading
Many traders always try to find a proper answer for the common question of where to make stop-loss placements reasonably. Placing stop-loss levels too close can make you get out of your trades too quickly. Meanwhile, setting the orders emotionally or too far from the entry price leads to big losses. Therefore, choosing the right stop-loss distance will guarantee your positions last long enough to oversee the value move in your desired direction.
Having said that, determining a suitable stop-loss level still depends much on various factors and techniques you choose on each trade.
Identify Your Risk
To identify stop-loss placements, investors should determine their risk tolerance beforehand. For instance, if you are confronting a $200 loss, what will you do next? Selling out your assets or waiting to see what will happen in the trade?
If you have $500 in your account balance, losing $200 would become a nightmare and you consider it as high-risk tolerance. Yet if your trading account size reaches up to $200,000, perhaps this 1% loss may not worry you.
This risk tolerance depends much on how you think of money. Determining the tolerance can help you identify at which stop-loss levels you should place to benefit your trading.
Determine Suitable Stop-Loss Placement Method for Trading Strategy
There are a variety of stop-loss placement measures in forex trading. No matter which method you adopt to diminish unexpected risks, please bear in mind that you should place a stop-loss level at a logical location where your trade setup is invalidated.
Many investors are advised not to risk more than 2% of their investment when applying a stop-loss order to their trades regardless of market volatility. This rule sounds decent to secure their trades.
For example, your current account balance has $500. You plan to open a EUR/USD trade with the minimum risk-reward ratio of 1:2 and the leverage ratio of 1:200. Subsequently, you can enter the trade with the account size of $100,000 and the pip value now equals $10 (0.0001 x 100,000).
According to the percentage method, you should risk no more than 2% of your trading capital (equals $6 – equivalent to 60 pips). Also, your trade setup can bring you a profit of net 120 pips. If the trade goes against you by 60 pips in which your trade idea is invalidated, you still feel comfortable with the loss.
This placement method is simple and easy to calculate a stop distance. However, because it does not consider market conditions and your trade setup, never exceeding over 2% is not always an optimal decision.
Besides, stop-loss orders should not be placed at the same level as the amount you are willing to risk. Normally, traders should not risk more than 1% of their capital (equals $3 or 30 pips in the mentioned example). This means that placing a 30-pip stop is infeasible as the distance is too tight to move.
Traders can consider a host of popular methods to set stop-loss orders at a right distance based on volatility by using different technical indicators such as ATR (average true range), Fibonacci levels or Bollinger bands. Of which:
The ATR indicator
Using the ATR indicator to identify the proper stop-loss distance for trades is very common as this measurement tool is available on many charting platforms. To calculate the stop-loss distance, traders should ascertain the average ATR value in their chosen time frames and then determine their stop-loss level by the multiple of ATR.
The ATR indicator is based on the price volatility (Source: MetaTrader 4)
Imagine you trade the EUR/USD on a 5-minute chart with the ATR of 0.06 which means the price is varying around 6 pips every 5 minutes. You could place a 6-pip stop as a result of multiplying the ATR value by 1, or an 18-pip stop which is 3xATR. The number relies much on how long you prefer staying in the trade and how much you want to earn.
Due to the correlation of the ATR with the price volatility, this indicator will become larger in a highly volatile market.
Bollinger Bands are a price channel that is displayed by upper and lower bands to demonstrate the statistically high and low values. Depending on the price volatility, Bollinger Bands will either widen when the price fluctuates sharply or narrow in a less volatile market.
This tool is widely used to trail stops and place normal stop losses. Accordingly, traders can set their stop-loss levels above or below the middle band with a small distance and move them along the band when the trade moves.
(Source: MetaTrader 5)
The chart-based method is related to using support and resistance levels to place proper stop-loss levels.
The support line (red-coloured) is placed under the current market price and connects low prices, whereas the resistance line (blue-coloured) is set above the current price and connects high prices. Traders do not expect a currency’s value to break those lines – in other words, not to be higher than the resistance level and lower than the support level. When the support line gets broken (as shown in the below picture), it should be erased and the new one will be created.
(Source: Earn Forex)
Accordingly, in the following figure, you can see the stop-loss and take-profit orders (red dashed lines) of the EUR/USD currency pair are placed slightly below the support and resistance levels respectively. When the value breaks above or below those levels, your trade setup will be no longer valid.
(Source: Earn Forex)
How Many Pips Should My Stop Loss Be?
There is no fixed number of pips to place a stop-loss order because the answer is based on different elements such as how much you are willing to lose and when you decide to exit a trade.
Many experienced investors advised using the ATR indicator to calculate the mean number of pips, whereas others shared experience of setting a stop-loss order between 30 to 50 pips on higher time frames. Too tight (like 20 pips) or too wide levels are not highly recommended.
Why is Stop Loss Important?
A stop-loss order plays a very important role in forex trading. We cannot precisely anticipate the future market, so every trade we enter is a high risk. Therefore, less-experienced traders are always advised to use proper risk management tools to protect their account balance from debts. A stop-loss order is one of those techniques.
David Rodriguez explained why forex traders lost too much money in two years 2009 and 2010. Looking at the graph below, you can see the number of pips traders earn from winning trades was recorded lower than that of unprofitable trades despite 59% of their profitable trades. This proves that the winning rate did not suffice to cover big losses from losing trades.
Failure is unavoidable in forex trading. Therefore, using stop-loss and limit orders can buffer the negative effects of the price movement on trades. The chart below indicates the importance of those tools on trading.
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