The subject of Stop Losses is vital to every Forex trader. Why? Simply put, the stop loss level is the ultimate level where a trader chooses to accept a losing trade. Stop Losses enable traders to cut their losses when appropriate. They are a necessity because Forex traders use leverage to maximize the potential gains from the Forex market.
We will start our article with a glance at leverage since it is the reason/culprit why we Forex traders absolutely must use stop losses. Then we will examine some of the rules and potential snags surrounding stop-loss strategies. Finally, we will look specifically at how trailing stops can boost the efficacy of a stop-loss strategy. Continue reading to learn all about stop-loss strategies and the ways you can use them to your advantage.
The Business of Forex
Forex traders enjoy access to high leverage (the use of borrowed funds to increase one's trading position beyond what would be available from their cash balance alone). However, leverage can be a double-edged sword with a significant amount of risk involved.
It is a simple business proposition for traders. The higher the leverage, the riskier the trading becomes. The riskier a trade, the more likely a trader will end up holding a losing position. Click here to read more about forex trader salaries.
Forex traders can access unusually high leverage levels. Anything up to 100:1 is common for forex traders, and nowadays, the leverage “mania” continues, and some brokers are even offering leverage levels close to 1000:1. Even if you only have $1,000 to trade, you can move up to $1,000,000 worth of capital.
Leverage is the Risk
Leverage is what makes the Forex business a risky venture. Think about it- If you own currency, are you at risk of a stop out? Is there a need for a stop loss?
When you own the currency, you own it. The risk you run is the devaluation of that currency in opposition to other currencies. You also run the risk of inflation and losing purchasing power in the future. But that is it. Owning and trading your currencies at a 1:1 rate is not as dangerous as other trading strategies.
The critical risk with forex trading is leverage. Using leverage is a risky business. Even if you use a forex position calculator, you may still lose money. If you use leverage and do not use a stop loss, you gamble and put yourself at risk of losing all your capital and getting a margin call. The risk disclaimers are there for a reason- they aren’t just a formality. The lower the leverage, the better, as the expectancy rate of your capital surviving and sustaining any string of losses increases.
With leverage the game is simple: you need to use it to protect your entire capital or trading capital.
Potential Stop Loss Issues
Stop losses are a valuable tool for any trader. However, because you use stop losses to protect your (trading) capital, you run a separate risk- your stop getting hit and losing your position.
Even if you have the best stop-loss price entry in the world, there is always a chance the market takes it out and goes in the direction which you anticipated. There is nothing we can do about that. This is a fact of life and trading.
To reduce risk, traders should find the most logical return to risk/ratio opportunities. Otherwise, these trade opportunities create a positive expected rate of return in the long term.
Another thing traders can do is find the best place for their stop compared to their type of strategy, the structure of the stop market, key levels, the time factor, a trader’s character & psychology, etc. We'll offer more on that later.
What is a Stop-Loss Order and How Do I Use It?
A stop-loss order, also referred to as a stop-limit order when used for gains, is a type of order that is placed with a broker instructing them to exit a position whenever a security has reached a certain price. Stop-loss orders can be used for forex, stock market trading, and securities trading.
For example, suppose a stock is currently trading for $100 per share. In order to make sure you minimize the amount of money you possibly stand to lose, you may issue a stop-loss order for $90. If the price drops below this level, your broker will then immediately exit the position (unless the order has been retracted). This means that even in the worst-case scenario, you only lose $10 per share.
Stop orders can be placed in the other direction to help you “lock in” potential gains on a given security. In this example, when a stock is trading for $100, a trader issues an order at $130. This creates an optimistic situation where the trader is yielding a 30% return on their investment.
Because the high exit point is three times away from the current mean as the low exit point, the reward: risk ratio in this situation is 3:1. The ratio can be easily adjusted according to your risk preferences and objectives. The purpose of using stop orders is to manage your exposure to risk and decrease the amount of attention you need to be paying to the market. They can be easily issued with any legitimate broker. Read more about how to choose a broker here.
The Rules of Stop Losses
When I was preparing this article, the first thing I did was examine the Trading Strategy Guides website. They are so many cool articles and I could not stop reading. When browsing and reading I bumped into an article from Nathan who mentioned 3 rules of using stop losses.
The rules are:
1) Always trade with a stop loss – protect yourself.
2) Define your own stop and define before you enter the trade.
3) Never move it unless absolutely necessary.
If you're feeling bold, check out our article on forex trading without stop losses here.
Checklist for a Forex Trader
When it comes to Forex trading, everything needs to be prepared. A famous Forex expression is to plan our trade and trade our plan. Here are some crucial aspects every trader needs to have in their
FX trading plan:
- Plan your trade before you enter.
- Use hard stops, even if you have a soft stop.
- Don’t exaggerate with the leverage levels and try to minimize them.
- Use adequate stop-loss sizes that realistically match your risk-reward preferences.
- Trade with sufficient Reward to Risk ratios compared to your win, break-even, and loss percentages.
- Stick to your plan after the trade begins: take profits as planned and never increase the size.
Stop Losses Are a Sensitive Topic
Traders should treat their stop loss strategy with care because improperly set stop losses can cause significant losses. Once exercising a stop loss, there’s no turning back. You lose your position. Therefore, it can be tempting to commit an action no trader should: moving the stop.
Read more about stop-loss risks and how to manage them by visiting the article: “Stop Losses Risk Management in Forex Trading.”
Most traders experience their stops getting hit at some point, after which they exit their position and the market reverses. This is an unavoidable aspect of trading, and traders shouldn’t take positions if they can’t handle the risks associated with them. Be sure to read these common mistakes around stop losses and cope with the loss of money after a bad trade.
Another thing that can happen is that the trade barely survives. After hours and hours of waiting, the trader decides to exit the position, only to see the currency move impulsively in the right direction. All traders have encountered this feeling, and it is a rough experience. It is demoralizing, and it can shake traders’ confidence.
It does not matter how tempting it might be, once you have a game plan, risk-tolerant traders stick to it. The temptation to ease the pain of a loss is overwhelming, but whatever the psychological issues that emerge, don’t change the stop. It is ok to have a loose stop as long as it fits your strategy setup. Simply put, forex traders must have a stop loss, but they have to stick to their stop-loss strategy.
Using stop losses to your advantage comes down to picking a strategy and sticking to it. As a forex trader, choosing a strategy comes down to understanding your options. There are a few subsections of stop-loss trades that can help you maximize your profits, such as trail options. The following section details trail stops- one of the options available to forex traders.
Using Trail Stop Options to Enhance the Efficacy of Your Stop Loss
Using a trailing stop is one of the most effective ways to enhance your stop-loss order. Trailing stops, unlike most stop-losses, are orders where the stop-loss price isn’t fixed at a single dollar amount. Instead, trailing stops set a percentage or dollar amount below the market price.
When the price on your position increases, it drags the trailing stop along with it. If the price stops rising, the new stop-loss price remains where the market carried it. Using trailing stops automatically protects your downside, locking in profits as the price reaches new highs.
But when does a trailing stop make sense? Is it better to use a take profit and a fixed reward to risk (R:R) ratio?
Insert Trailing Stop or Hard Profit Video Here: Link: https://www.youtube.com/watch?v=-FpA8RkEebI
You also need to ask yourself the following questions when considering when implementing a trailing stop stop-loss.
- Do you use trail stops?
- Have you tested the trail stop effectiveness before using it?
- If you do not use it, why not, and what do you think is better?
Trail Stop Options
There are various ways of implementing a trailing stop. Here is a list:
- An immediate trail stop in the same time frame.
- An immediate trail stop on a higher time frame.
- Trail stop after a target has been hit.
- A mix of hard take profit and trail stop.
- Increasingly tighter stop loss when in higher R:R levels.
- Discretionary (open for later decision: no take profit or trailing stop).
Various methods can be used for a trailing stop:
- Bollinger bands
- Swing high, swing lows
- Support and resistance
- Fibonacci levels
- Parabolic SAR
- Moving averages
What do you think is best? Which method would you add to the lists above?
Trail Stop Balance
The advantage of the trailing stop is that a Forex trader lets some of their winners run and cuts some of their losses short. This is a compelling concept in Forex trading, where increasing one’s average R:R win versus average R:R loss is a pivotal part of becoming profitable. Here are some important notes that deserve attention.
- Traders need to test their trailing stops for their efficacy and profitability before implementation. A seasoned forex trader tests how various trail stops fit their strategy for different trades (typically a couple hundred) to gain insight into whether the trailing stop is more effective than a TP. It is essential to review the long-term data such as the profitability, drawdown maximum, average win, average loss, number of maximum losses, and the number of victories that win more than the maximum loss compared to total wins. This information provides details on which system has the best balance.
- Avoid over-analyzing data. This part of forex trading deserves time and attention, but every trail stop and hard take profit will have certain disadvantages and advantages. Forex traders need to accept that one particular method will never be perfect. There will always be examples where a specific type of trail stop works better than the other.
A note on trailing stop psychology:
A chosen trade management method must always be in sync with trading psychology. As with any other trading strategy, forex traders deciding on trailing stops need to balance their strategy, risk management, money management, and mental biases.
Trailing Stop: Advantages vs Disadvantages
Both the trailing stop and the take profit levels have certain advantages and disadvantages.
Benefits of a Trail Stop
a. A trailing stop allows the market to decide how far it wants or does not want to go instead of the Forex thinking for the market. The Forex trader thereby “rides the tide” and “goes with the flow.”
b. Trail stops eliminate some of the fear tied to losing capital, resulting in more evident trading strategy approaches. The trailing stop helps protect the trading capital by locking in more minor losses.
2:1 R:R back down to a complete loss. This idea could create serious problems, such as a Forex trader “clicking out” a trade earlier than planned.
c. A trailing stop allows for massive wins – occasionally. These huge wins can spike traders’ equity curves to new levels.
Benefits of Taking Profit
a. Take profits have a smooth equity curve compared to trail stops because the answer is always simple: either a win or loss. Trail stops can create smaller wins, smaller losses, and occasional bigger wins, which creates a more volatile equity curve.
b. The Reward to Risk ratio is easier to calculate with a take profit strategy because the potential reward is a given.
c. A take profit requires less trade management time. With precise levels where a Forex trader wants to exit the market for a loss or profit, it’s easier to create a “set and forget” mentality. Trailing stops require attention to the adjusting market.
When To Use and Not Use Trailing Stops
Deciding when to use trailing stops comes down to knowing your strategy and contemplating the best approach. An intra-day trader might not want to use a trailing stop because they prefer closing their position before the close of the trading day. They might also give up too much profit compared to the expected daily range.
While swing traders don’t have the same time constraint as intra-day traders, they still need to create a time-sensitive trailing stop because Forex traders cannot monitor the markets all the time.
Because of this, swing traders should either create a trailing stop, which can be monitored by reviewing the charts a couple of times a day, or trading in a group of traders who constantly check the positions.
Also, there is the question of which stop-loss strategy traders use. A Fibonacci strategy uses Fib levels as a take profit level. A break-out strategy, however, could be suitable for a trailing stop.
Then again, for a range strategy, the take profit level could be better suited. A reversal trade might want to incorporate a trailing stop after a certain profit has been reached. In contrast, a trending trade setup could seriously benefit from a trail stop loss as the price extends in one direction.
The Big Question: Where to Put the Stop Loss?
The example of implementing trail stop orders to increase efficiency on your stop-loss brings us to another critical decision with stop losses: where to set your stop loss.
There are two primary problems to consider when setting your stop loss:
- You can place the stop too close to the market. A vital sign of this is whether you see many stops initiating, after which the trade materializes as you originally planned. The added risk which wider stops create can be compensated by reducing the lot size.
- In other cases, you might hit your profit targets but realize that your reward does not sufficiently compensate for your risk. In those cases, you should consider tightening your stop loss size.
But there are other keys to correctly placing your stops. Read here a great article about using tight stop losses.
- Currency pairs vary in terms of volatility, spikes, and average distances daily. It is recommendable to study the currencies you regularly trade.
- The type of stop-loss depends on your strategy. Stops can differ depending on the strategy you choose. For example, trending strategies are different from ranging strategies.
- The time frame you use for trading affects your stop placement. Using a shorter time frame requires traders to use more minor stops to enable a decent reward compared to risk. Stops for such a scalp/day trade should differ from that of a trade taken for a swing, based on the daily or longer timeframes.
- Study significant Fibonacci levels, key resistance, and key support levels on higher time frames.
- Your trading character and trading psychology are essential to consider. Can your mentality handle a small stop? Are you able to live with a 150 pip stop loss?
- How does the structure of the market look? Is the currency chopping and going sideways, or is there a clear pattern visible?
Read more about forex chart patterns here.
Levels to Consider
Here are some concrete tools which you can use for your trading to actually place your stop. I am sure there are more examples but here are a few of them:
- Fibonacci retracement levels.
- Tops and bottoms.
- Swing highs and swing lows.
- Candlestick highs and lows.
- Invalidation levels of the Elliott Wave Theory.
- Consolidation zone / resistance – support areas.
- Trend lines.
- Trailing stops.
- Technical Analysis
Conclusion- Stop Losses: The Ultimate Guide for a Forex Trader
Forex traders can use stop losses to mitigate the risk caused by high leverage. However, to minimize the risk associated with lost capital, traders must apply stop-loss strategies in a savvy manner to their trades. Doing so requires a thorough analysis of factors such as Fibonacci retracement levels and candlestick highs and lows and others.
Trailing stops represent a valuable strategy to forex traders looking to maximize their stop loss efficacy. However, there are other strategies, such as take profit, that can accomplish the same end. The most successful forex traders understand how to use these tools when appropriate.
Trading Strategy Guides is committed to giving traders the tools they need to create sustained growth and value. Use the following list of articles for further reference on stops and how to use them to your advantage.
Reward to risk:
- Maximize profits and minimize risk
- Minimizing risk, Maximizing reward
- Using 2:1 R:R
- Zero To $1 Million Forex Trading Strategy
- Parabolic Sar Stop Loss Strategy
- Exponential Moving Average Stop Loss Strategy
- ATR Stop Loss Strategy
- Forex Trading - Setting Realistic Income Goals
Ok, folks, that’s it for today. I hope you enjoyed it.
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You can find the second part of the article here which will give you practical examples where you can actually place stop losses, using the tools mentioned above. We also have training for trading forex without stop losses in our best hedging strategy article.
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