The subject of Stop Losses is very important 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 quick glance at leverage since it is the reason/culprit why we Forex traders absolutely must use stop losses.
The Business of Forex
To be honest, I would not be surprised if businesses are jealous of Forex traders because of their fast and easy access to so much the capital. Then again, the high leverage is not given and granted to Forex traders because banks are being generous. These banks have very specific strategies. Why can Forex traders have access to such high levels of leverage?
It is a simple business proposition for them. The higher the leverage the riskier the trading becomes. The riskier the trading is, the more likely a trader will end up holding a losing position. Click here to read more about forex trader salaries.
Traders are actually able to access very high levels of leverage. Typically anything from up to 100:1 is very common and nowadays the leverage “mania” continues and some brokers are even offering leverage levels close to 1000:1. In these situations, even if you only have $1,000 to trade with, 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 actually own currency, would you get stopped out? Would there be a need for a stop loss?
When you own the currency, you own it. The risk you run is the devaluation of that particular currency versus other currencies. You also run the risk of inflation and that the currency amount you own has less 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 strategies.
The key difference is when you add leverage to the mix. Using leverage is a risky business. Even if you use a forex position calculator, you may still end up losing money. If you use leverage and you do not use a stop loss, you are gambling and you are at risk of losing all your capital and getting a margin call. The risk disclaimers are there for a reason, not just for the formality. The warnings are not nonsense. 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.
The Stop Loss Problems
Without any doubt, a stop loss is a must. But because you must use it to protect your (trading) capital, you do run a different risk. 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. This is a fact of life and trading.
What we traders must do and the only thing we can do is find the best return to risk ratio opportunities that succeed often enough. Otherwise, these trade opportunities create on average a positive expected rate of return in the long term. Another thing traders can do is find the best place for their stop in comparison 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 on.
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
The first thing I did when I was preparing myself for this article is to look through 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:
1. Plan your trade before you enter.
2. Use hard stops, even if you have a soft stop.
3. Don’t exaggerate with the leverage levels and try to minimize it.
4. Use adequate stop-loss sizes that realistically match your risk-reward preferences.
5. Trade with sufficient Reward to Risk ratios in comparison to your win, break-even, and loss percentages.
6. Stick to your plan after the trade begins: take profits as planned and never increase the size.
Read more about forex trader income
Stop Losses = Sensitive Topic
Basically, the entire topic is a very sensitive matter for traders because simply put, the stop loss has the potential to cause the actual loss. Once a stop loss has been exercised, you will have formally exited your position. Therefore, there could be a temptation to do something no trader should ever do: to move the stop. They can bite.
Read more about them and how difficulties associated with it in this article: “stop losses risk management in Forex trading.”
Many a trader has gone through the experience of the phenomena where their stop gets hit, after which they see the market reverse back into their direction without them.
Be sure to read these common mistakes around stop losses and how to cope with the loss of money after a bad trade.
Another thing that can happen is that the trade barely survives but after hours and hours of waiting, the trader decides to take off the trade, only then to see the currency finally move impulsively in the right direction. All traders have encountered this feeling and it is a rough experience. It is very demoralizing and it shatters the trader’s confidence. It can lead to a trader becoming fearful or reckless. The emotions which can be triggered are very real and dangerous and impede a trader from achieving success.
It does not matter how tempting it might be, once you have a game plan, you must stick it. The temptation to ease the pain of a loss could overwhelming and the fear of losing might be tremendous, 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 the strategy setup you are using and you have planned it in advance.
So to sum it up, due to the leverage element of Forex trading, Forex traders must have a stop loss. We must define a level and must never move our stop, however tempting that might be to avoid the pain of a losing trade. You will be setting yourself up for failure and run the risk of blowing up your account. Never forget that the first goal of Forex trading is to ensure the preservation of the trading capital. When the capital is lost, there is no trading day tomorrow or next week. To know more also read about Trailing stop or hard take profit.
The Big Question: Where to Put the Stop Loss?
Forex trading will always create losses. That is the nature of the market and nothing we do will change that. However, traders are not helpless. There are definitely aspects a trader must consider to improve the quality of their stop losses.
Usually, there are two different types of traders:
1) For example, in some cases, the stop could be placed too close to the market. A key sign is whether you see many of your trades are being stopped, while later on the trade does actually materialize as planned. The added risk which wider stops create can be compensated by reducing the lot size.
2) In other cases, you might be hitting your profit targets but realize that your reward is not sufficiently compensating your risk. In those cases, you might want to consider tightening your stop loss size.
But there are other keys and crucial elements to consider with regard to the best stop placement. Read here a great article about using tight stop losses.
1) Currency pairs vary in terms of volatility, spikes, and average distances on a daily basis. It is recommendable to learn and get a feel for the currencies you trade regularly.
2) The type of stop-loss depends on your strategy. Stops can differ depending on the strategy you choose. For example, trending strategies are different than ranging strategies.
3) The time frame you use for trading. Using a shorter time frame requires traders to use smaller stops to enable a decent reward to risk. Stops for such a scalp/day trade should be different from that of a trade taken for a swing, based on the daily, or higher timeframes.
4) Where are big Fibonacci levels, key resistance and key support levels on higher time frames? These can provide great shelter for them.
5) Your trading character and trading psychology are important to factor in as well. Can your mentality handle a small stop? Are you really able to live with a 150 pip stop loss?
6) How does the structure of the market look like? It 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:
1) Fibonacci retracement levels.
2) Tops and bottoms.
3) Swing highs and swing lows.
4) Candlestick highs and lows.
5) Invalidation levels of the Elliott Wave Theory.
6) Consolidation zone / resistance – support areas.
7) Trend lines.
9) Trailing stops
10) Technical Analysis
More on Stop Losses
There really is tons of great value on the Trading Strategy Guides website that you do not want to miss out on. So I am going to make a very easy list for you that summarize the topics connected to Stops. Make sure to read through them this weekend.
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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