What Is A Stop Loss And How To Use It In Forex Trading?
A stop loss (SL) is an order placed by a trader to close a position at a defined price, stop losses are used to limit losses on a trade. No trader can be right all the time which makes stop losses a great asset for protection against unfavourable moves.
Here is what will be covered in this article:
- How to use stop loses.
- Chart examples.
- Advantages and disadvantages of stops.
How to use stop losses
1. Limit risk on a trade
As mentioned already traders can utilize stop losses to limit their initial risk on a position. This is done by placing a stop order as soon as a trade is placed. Once price reaches the specified level, the position is automatically closed for a loss.
In a buy position, the stop is set below the entry price vs a sell position where it is set above the entry price.
Here is an example of setting a stop loss.
The market is approaching a major support level, this could be an opportunity to place a buy trade. On the H4 we will check to see if there is an opportunity to enter.
On the H4 the market printed a bullish candle on support. After buying GBPUSD we can place the stop loss below the zone of support to limit the initial risk on the position.
An important point is that you should never base the placement of your stop loss on factors such as how much volume you want to enter with or how much profit you would like to make. A stop loss should be set based on the visual representations on supply and demand on the chart such as support/ resistance, highs/ lows and trendlines.
The point at which you place your stop should be the price at which your forecast is deemed to be incorrect. Furthermore, stop losses should be given leeway from the current market price because support and resistance act as zones. Therefore, price may push slightly past levels before moving in the desired direction and nobody wants to be stopped out before that.
2. Lock in profits
Take profits are generally used to close out winning trades, but stop losses are multitalented as they too can also be used to lock in profits. Stops used to lock in profits are known as trailing stops.
Utilizing trailing stops involves moving the stop order in the direction of your winning trade i.e. in a buy trade the stop is trailed upwards as the position moves in your favour and in a losing trade the stop is moved down as the position moves in your favour.
Trailing stops can be moved manually, like normal stops, and can also be trailed based on price movements e.g. the stop can be set to move 20 pips away from the current market price and will adjust as the market moves. On the chart below we can see the use of trailing stops.
After a sell position was executed price moved in the trades favour, each time a new lower low is made the trader can manually adjust the stop above the previous lower high. The opposite would apply to a buy position.
To learn more about trailing stops check out the following article.
Advantages of stop losses
Foremost, as already mentioned, stops allows traders to manage risk by ensuring that a trade is closed when the market responds unfavourably.
Trailing stops also prevent profits from being significantly reduced when the market reverses against our winning positions.
In this way, stop loses allow a trader to cut the loses and let the winners run. The perfect risk management recipe for profits.
As all traders learn, psychology affects results just as much as actual trading does. Stops empower a trader to take control of emotions as there are objective rules to follow preventing fear and greed from influencing trade management.
Disadvantages of stop losses
The only disadvantage of stop loss orders that I can agree with is that slippage (or spread) can lead to execution of the stop loss without price actually touching the level. Premature exits such as this can lead to the market heading in the correct direction without you being in the trade, and all traders know how much that hurts! Prevention of this occurring frequently is simple, as mentioned, the market must have enough “wiggle room” until the forces of supply and demand take effect.
Some people are of the opinion that gaps are also a weakness of stop losses. Opinions like this exist because if the market gaps past a stop loss then a trader would not be stopped out at the price they set, but rather the price that the market gapped too.
This can result in losses far larger than the max loss the trader determined beforehand. However, I disagree with this because if the market gaps strongly against your position then it is best to get out of the market anyway otherwise emotions take control via hope that the market comes back. All the stop does is get you out faster.
If you are not using stop loses in your trading its time to make a change. Hopefully, this article helped to explain what stops are and convince traders to use this great asset. After all, they are the best way to follow the trading rule…
Cut losses short, let winners run.