Stop-Loss Order

Stop-Loss Order

A Stop-Loss Order is an order placed with a broker after a trade entry that automatically closes a losing position once the market reaches a particular price within the trader’s risk profile. It is designed to limit a trader’s loss on a position. It is a defensive mechanism that can be initiated to protect an order against deeper losses, including margin calls or account blowouts. It can be mental or automatic/hard.

 

A mental stop is one where a trader closes out a trade manually once price moves to a certain level. With a mental stop, a trader may have a price in mind, but really does not take action until they see their stop price reached but may or may not follow their trade exit rule. While an automatic stop is one that’s present and entered. They always follow the market and will close your trade almost guaranteed at the pre-specified price, preventing heavy losses on a losing position.

 

Many traders trade without hard stops for fear of stop hunters going after their stops. Much as stop hunting could be real, much of what’s thought to be stop hunting is actually slippage and tends to hurt lower timeframe traders due to very tight stops. And given the price reaction especially during times of macroeconomic data releases, the market experiences price spikes due to slippage that can easily hit a stop loss and sometimes even go beyond it when there’re price gaps.

 

Slippage is an unavoidable trading risk. A stop-loss automatically closes an open position when the exchange rate moves downward to the level specified in the order, much like a take-profit order closes a trade when a predetermined profit has been attained. It is important to understand that stop-loss orders can only restrict losses — they cannot prevent losses in fast moving markets

 

Where To Place Stop-Loss Orders

Usually the best place to set a stop-loss is below or above a swing high or low, depending on the trade position whether it’s a long or short. This is because of the assumption that by the time prices moves below or above a swing high or low, the short term trend has already changed and you’re better off out than maintain a trade against the trend. The other reason is that when price breaks for example above a swing high when your position in the market was a short, chances of price reversing in your favor are slim as the broken swing high might is resistance now turned support and lower prices may be rejected on retracement to it necessitating an early exit to a losing sell position at a swing high level.

 

In the case where a traders traders the break or the low or high of candlestick formations, say for example a Pin bar, its important that the stop-loss is placed at least below the pin bar in case of a long position, or above it in case of a short trade. This is because price has a tendency to retrace after the break before finally moving in the direction of the break. In such a case,  if the stop had been placed in the middle of the candlestick formation, it would lead to an early exit in loss of what would have been a great profitable trade.

The stop-loss could also be placed below pivot areas or below Fibonacci levels. Pivot points and Fibonacci levels are used to determine price retracement areas and therefore could as well act as a guide to stop-loss areas below or above areas of expected price retracement. For example if price retracements are so strong and extreme, they tend to get to the 78.6% level. If price goes beyond it, its likely price direction has shifted and it wasn’t just a retracement. In such a case its always important to set your stop-loss below a level deemed safe

 

It’s also safer to set them below or above breakout areas in case one had traded a price rejection of an area of support or resistance. This is because price has a tendency of false breaking out of the support or resistance area before reversing and the rejection area holding. And if you had set the stop-loss at the area, you would have been taken out by the false break despite your prediction of price direction being accurate.

 

 

Importance Of Stop-Losses

Losses are inevitable when it comes to forex trading, and indeed any other market for that matter. So losses have to be appreciated as an undesired but acceptable reality in this business. It’s a reality you cannot avoid no matter your trading prowess. The best you can do is to control and manage it, hence the need for stop-losses use.

 

The main purposes of a stop-loss order are to reduce risk exposure by limiting potential losses and to make trading easier by already having an order in place that will automatically be executed if the market trades at a specified price without you necessarily having to monitor the charts. It’s paramount for traders to always use stop-loss orders whenever they enter a trade, in order to limit their risk and avoid a potentially catastrophic loss. In short, stop-loss orders serve to make trading less risky by limiting the amount of capital risked on any single trade.

 

Stop-losses prevent large and uncontrollable losses in high volatility periods. If you’ve been in the market during news releases and macroeconomic data events you fully understand the aspect. If you let your losses run without using stop-losses, before long the losing position grows and eventually gets out of control. Unfortunately, by then it has wiped out most of your trading profits, and sometimes led to margin calls.

 

If you’re serious about thriving in the forex trading business for the long haul and growing your capital, it’s necessary to use stop-loss orders in every single trade you’re taking. Stop-losses help in managing risk. Traders who use stop-losses usually limit their losses to a certain dollar amount or a specific percentage of the account size. This ensures accountability and disciplined sensible trading.

 

Handling And Application Of Stop-Losses

 

There’s a group of traders who don’t trade with stop losses. Reason? The broker will stop hunt their position. Much as this may be true in a small bit especially with market maker brokers, its mostly false. Most traders particularly new ones don’t understand the issue of spreads. So while setting their stop losses, they do not adjust them to make room for spreads. As such their trades are closed prematurely. And when it comes to scalpers trading the lower timeframes, its even worse the fact that their stops are usually tight. Its not uncommon for a position to hit stop loss set as far as twice the length of the candlestick in a lower timeframe without actual price ever getting to the stop loss level. This is more common in exotic currency pairs. That’s why the topic of Stop Losses is extremely important to every Forex trader.

A very simple way of looking at stop losses is to that it’s the extreme point at which a trader is willing to accept a loss. Of course price could still have reversed in that case to reach his previously set target profit but trading is a business based on probabilities not hope. Its about rationality based on what ‘is’ not what ‘might’ be. Stop Losses help traders manage risk by controlling their losses. They help them cut losses when appropriate. Forex traders use leverage to maximize the potential gains from the Forex market. So they are a necessity.

 

Stop-Loss Challenge

Trading without a stop loss is akin to gambling. Stop losses are simply a must and it’s not even debatable. However, sometimes it can be a double edged sword in the sense that it can take you out of a trade prematurely. Recently I placed a short sell and even adjusted my stop loss to cater for the spreads. But when the session closed towards the Asian open, the spreads exponentially increased and knocked me out of the trade with a minor loss without price ever getting to my stop loss level. Off course it was a case of bad broker whose spreads are usually extremely high. I had chosen them because if their good leverage but their spreads are a put off and can have you lose trades that would otherwise have been profitable on other brokers’ platforms. So the fact that you must use stop losses in trading to protect your capital, you’re running a different risk altogether.

 

Like the example above, you run the risk of your stop getting hit and your trade taken out. Even if you have the best stop-loss price entry in the world, there is always that chance where the market takes it out and then goes in the direction which you anticipated. There is nothing we can do about that. That’s the trading for you, yet the stop loss is a necessary evil. To beat this you need a very good regulated broker that offers better spreads on the instruments you trade and then incorporate in your trading the Risk:Reward concept that ensures you gain more on your wins than you lose  on your losses. That done with a good trading strategy, you will win overall with a series of trades. That means one has to be psychologically grounded to handle the losses, but that’s a topic for another day.

 

Understanding The Stop-Loss

 

 

A stop loss is a limit order placed by the trader against a trader’s position in the market with a broker instructing the broker to exit the trader’s position whenever a price the traded instrument has reached a certain price level. Traders usually set stop losses as percentiles of their total trading capital. They are used across all financial markets including forex, cryptos, commodities, stocks, or indices.

 

This helps a trader to ensure that in the case of a drawdown on their trade, their loss doesn’t exceed a certain percentage amount of their trading capital and they live to trade another day. Stop losses are not only used to stop a loss on a losing trade but also to protect gains on a trade. when a trade  is going good and is deep in profits, you don’t want to give back your profits to the market. So you trail your profits at a safe distance to prevent premature closure with a (trailing) stop loss. This ensures that in the case of price reversals where you your winning trade reverses before reaching your target you in the worst case scenario lose a portion of your profits on the trade but bank some that were already safe in the trailing stop loss zone.

 

Guidelines On Stop-Losses

Stop-losses are not random placements, they are planned and measured. They are determined ahead of time before ever placing a position in the market.

 

Plan your trade before entry. Of course it should be in percentage terms fractional to your entire trading capital. For example, the rule of the thumb when it comes to trading is that you don’t risk more that 1percent or in extreme cases 2percent of your entire trading capital on a single trade. What this means is that in the case of a losing trade, the amount you’re willing to lose should not exceed 1percent of the amount you hold in your trading account. Let’s say you have $1000. You place a trade but the trade goes against your position. You let it run but exit it when it gets to $10 in the red. What the stop loss order does is to exit the position once it gets to negative $10 automatically so you don’t have to be staring at the computer waiting to close the position manually.

 

Determine the stop loss level. This should be a level that’s safe enough. We know that price usually retraces to retest certain levels before continuing in the anticipated direction. So you may be right about the direction and still lose the trade. Place it at a safe distance. This could be below in the case of longs or above in the of shorts certain levels such as:

  • Support and resistance
  • Fibonacci levels
  • Pivot points
  • Tops and bottoms
  • Swing highs and lows
  • Candlestick highs and lows
  • Invalidation levels of Elliot Wave Theory
  • Trendlines
  • Fractals

 

After determining the stop loss level, use the appropriate lot size that limits your loss to the desired fractional percentage of your entire capital. This is called risk management. You can’t randomly trade standard lots or mini lots. Unless you are risking the same amount of pips for every trade. otherwise you would need to calculate it first. Different currency pairs have different pip values. You can use the free lot size calculators available online to help you calculate the appropriate lot size.

 

Use hard stops and not mental ones. A hard stop is one that is placed ahead of time and is inflexible unless moved. A mental stop on the other hand is one where a trader has a price level in mind but really doesn’t take action until they see price reach their stop loss price level at which time they may or may not manually close the trade. The problem with a mental stop is that its not reliable in times when there are erratic price moves and slippages

 

Never move your stop loss until the trade is comfortably in profit, preferably at least 1:1 reward risk, or when price breaks certain market structures. The purpose is to leave your trade enough wiggle room. No matter the temptation, once you have a game plan, you must stick to it.

 

Godfrey Kakulu

Forex Trading Coach and Mentor

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