Using Stop Loss Orders

Forex trading can very often involve making a lot of unsuccessful trades and just a few profitable trades. It is absolutely essential that the losses on unsuccessful trades are minimized and the profits maximized on winning trades. That may sound somewhat simplistic and rather obvious, but the fact is that many Forex traders, particularly relatively inexperienced ones, make the same repeated mistakes - hoping a bad trade comes good rather than cutting losses, and holding out on profitable trades for too long.

Even the most profitable Forex traders will make many bad trades – they just have the discipline to limit their losses on those trades and more than make up for them by getting out at the right time on the successful trades. Good money management and strong discipline is absolutely imperative for a Forex trader; this article looks at one of the methods for minimizing losses on bad trades – the stop loss order.

What is a Stop Loss Order

There are many different types of order that a Forex trader can place. The stop loss order is one that is used primarily to limit the potential loss of taking any particular position. When placing a stop loss order, the trader sets a price at which the security is to be sold. For example, a trader may wish to limit their potential losses on a particular currency they are buying to 10%, so they would place a stop loss order with the stop price at 10% below the price they paid. Stop loss orders can also be used when selling short, by setting a stop loss above the price at which a position was entered.

Benefits of using a Stop Loss Order

As already mentioned, it is important to cut your losses on bad trades if you want to be consistently successful at Forex trading. This means that if you make a trade and prices move in the opposite direction than you expected, you must be prepared to exit your position. One of the biggest advantages of using stop loss orders in Forex trading is that it enables you to exit your position on a trade without the need to constantly monitor price fluctuations in the market. By placing a stop loss order, you have a fixed exit point that is transacted if your trade does not work out as planned. This can be useful if you are trading part time and do not have the time to watch market movements on a daily basis. It is also beneficial to those traders that hold a lot of positions at any one time and have to track the movement of a lot of prices.

The stop loss order is also particularly useful for helping to avoid one of the biggest mistakes that many Forex traders make; letting emotion get in the way of rational decisions. A lot of Forex traders – or indeed investors of any kind – all too often get emotionally attached to a trade (or investment) and make incorrect decisions because of that. It is not uncommon for a trader to hold on to a position for longer than is advisable, because they refuse to believe their initial decision was wrong or they hope that the situation will turn around. Not getting out of a trade that has not gone as expected can end up being very costly. If a trader has a tendency to let emotion get in the way, or lacks the discipline to exit a trade at the right time, then the stop loss order can prove very valuable.

Another benefit of using the stop loss order is that there is no direct cost associated with placing it. If the stop loss that you set is reached, then the required trade will be executed and you will be charged your usual commission but there is no additional cost incurred. It is essentially a free insurance policy that protects you against unforeseen price movements by limiting the amount that you lose should that happen.

It should be noted that one potential disadvantage of using the stop loss order is that a stop price could easily be reached due to a movement in price that is largely due to short term price fluctuations rather than the beginning of any real momentum in one direction. This is especially true in markets that fluctuate to any great degree on a regular basis – such as the Forex market. This should be taken into consideration when setting the stop price; for example if a currency has a history of fluctuating 5% or more on a regular basis then the stop loss should really be greater than 5%.

Trailing Stops

While the stop loss order is largely thought of as a useful tool for limiting losses, it can also be used as a method for protecting profits too - by using a trailing stop. When you set a trailing stop on a stop loss order, the price is not set a percentage below the price you bought at but rather at a percentage below the current market price. The trailing stop therefore moves as the market moves, meaning that you can let your trade run and increase your profits, and protect those profits if the price move reverses.

Stop Loss Limit Orders

A standard stop loss order is what is known as a stop loss market order. This means that when a stop price is reached, a market order is entered to sell the security (or buy if a short position has been taken) at the market price. While this means that the stop loss order will always be executed, if the price is moving quickly, you will have no control over the exact price at which the order is executed. For example, you might be set a stop price at 10% below the price you bought currency at, but by the time is order is executed the achieved price may be greater than 10% below the original purchase price.

The alternative is a stop loss limit order. This is effectively a combination of the stop order and a limit order – meaning that once the set stop price is reached the order becomes a limit at a certain price or better. This gives you more control over the price at which the order is executed as you can define precise parameters. However, the downside to this is that the order is not guaranteed to be executed if cannot be filled within the limits you specify.

The stop loss order is a useful that all Forex traders should be aware of. Used correctly it can be of great benefit in helping to limit losses and lock in profits. It does not, of course, guarantee success but it can certainly help to improve your chances.