What is a Stop Loss Order and when must you use it?
WHAT IS A STOP LOSS ORDER AND WHEN MUST YOU USE IT?
A Stop Loss Order is a very simple tool that can prevent excessive losses on forex positions. It’s also highly effective to lock in profits. Stop Losses are like silent bodyguards standing by to save you from getting seriously hurt in a trading deal.
Market orders convey instructions to brokers to buy and sell at the current or a specified price. Stop Loss Orders are just one of many risk management tools available on trading platforms like MetaTrader that are designed to protect traders from spiraling losses.
As long as there are willing sellers and buyers, market orders are executed. Stop Loss Orders are guaranteed to be executed but the profit or loss made depends on factors such as volatility, liquidity and slippage.
Why Stop Loss Orders exist
Forex traders know how valuable the money-saving Stop Losses are but funny enough, many investors and traders either don’t use them or they don’t use them properly. A Stop Loss Order is just one of those disciplines you need to adopt when trading forex, like automatically pulling up your handbrake when you park your car.
The best thing about Stop Loss Orders is you don’t have to constantly monitor the positions you hold. They’re designed to automatically limit an investor’s loss trading an underlying asset and lock in any profits so you don’t have to watch your screen all the time.
The only downside is if they activate due to a short-term fluctuation, a Stop Loss Order can trigger an unnecessary sale and result in losses anyway. However, there are other methods to limit losses to counteract this one weakness.
How does a Stop Loss Order work?
A Stop Loss Order is set at a specified amount of pips away from the entry price. Pip stands for Point in Percentage and it’s the unit of measure used in the forex market to define the smallest change in value between two currencies. In a typical currency pair quote, a pip is represented by a single digit move in the fourth decimal point.
For example, if the price of a currency pair moves from 1.1905 to 1.1906, it would be a one pip movement.
All brokers allow their clients to set Stop Loss Orders and in fact, encourage it. It’s in the broker’s best interest that clients are protected from spiraling losses, can keep their positions open and lock in profits.
For this reason, setting up a Stop Loss Order of any sort is free. In other words, brokers do not charge a transaction fee for Stop Order instructions.
When a Stop instruction is executed on a trade, it’s the brokers job to get traders the best possible price nearest to the Stop price. Traders usually get a price a pip or two away from the Stop price, depending on the liquidity of the underlying asset.
The difference between what the price that the trade is stopped at and the price the trader actually gets for the asset is known as slippage. All forex traders factor slippage into their trading plan.
When is a Stop Loss Order set?
A Stop Loss Order can be set for a long position and a short position, which makes it a highly versatile trading tool regardless of the strategy a forex trader is following. The order is executed only when the price of the currency drops to a specified price.
The forex trade is stopped at the specified level to prevent further losses. However, this doesn’t mean that the asset is instantly sold at the price. The Stop Loss Order becomes a Market Order and profits and losses are made on what the asset sells for at that price.
Why traders set Stop Loss Orders
There are two reasons why traders set Stop Loss Orders on forex positions. The first is they stand in for you when you’re not at your PC or on your mobile forex trading app. This is particularly relevant to new traders who trade forex on a part-time basis.
The forex market is open 24-hours a day, 5-days a week. It’s impossible for anyone to monitor their screens day and night. Setting Stop Loss Orders means you can rest assured that you won’t make a significant loss while you’re sleeping.
Secondly, Stop Loss Orders take the emotion out of closing a position. Stop Loss Orders at times can work against you when they stop a forex deal too early but on the whole, Stop Loss Orders help traders keep a check on their fear and anxiety when going long or short on a position.
Stop Loss Orders take the pressure off traders and allow the position to run its course according to the traders strategy. The automated process of setting up Stop Loss Orders also eliminates the risk of making an emotional decision on positions during volatility or during short-term fluctuations.
Disadvantages of Stop Loss Orders
The only real disadvantage of Stop Loss Orders is traders sometimes lose money on a trade if the Stop Order is activated too soon. This can be a problem in volatile trading conditions where the currency pair is experiencing short-term fluctuations.
To overcome this, forex traders choose a Stop Loss percentage that accommodates day-to-day fluctuations. If an underlying asset has a history of fluctuating 10% or more over a period of a week, a trader will choose a Stop Loss percentage in that scope.
Typically, intraday traders choose a narrow (5%) Stop Loss percentage on short-term positions and long-term investors choose a broader (15%) percentage.
Bear in mind that the price you eventually sell the underlying asset for may not necessarily be the same as the pre-determined Stop price. This is because once traders reach their closing price, the Stop Order becomes a Market Order. Depending on the liquidity of the underlying asset, traders risk further losses if there’s limited uptake at that price.
How to set Stop Loss Orders
Traders place a Stop Loss Order with their brokers which is an instruction to buy or sell once the underlying asset reaches a certain price. The Stop Loss instruction is automated, set up through a trading platform like MetaTrader 4.
If you set a Stop Loss Order for 10% below the price that you bought the underlying asset, then this will limit your loss to 10%. In other words, you cannot lose more than 10% on a position if the price moves in a different direction to what you anticipated.
Step-by-step guide to using MetaTrader 4 to set Stop Loss Orders and lock in profits
On MetaTrader 4, Stop Loss Orders are set on Pending Orders. You will notice that the Stop Loss tool is disabled on a trade set on Market Execution.
This is to allow traders to enter a forex trade as quickly as possible when the price is already moving. Traders set their Stop Loss Orders on these trades by modifying the trade after it has been entered.
Setting a Stop Loss Order on Pending Orders
Click the New Order button
From the drop-down list, select the currency pair you want to trade.
Select Pending Order from the Order Type dropdown list
Select Buy or Sell for the currency pair in the Order Type dropdown list
Select the management risk option available for the Buy or Sell order
- Buy Limit: if you plan on going long (buying) at a level lower than the market price
- Sell Limit: if you plan on going short (selling) at a level higher than the market price
- Buy Stop: if you plan on going long (buying) at a level higher than market price
- Sell Stop: if you plan on going short (selling) at a level lower than the market price
Set the price at which you wish to enter the market on a currency pair trade
Enter the size of the position you want to open the volume field.
Fill in the Stop Loss and Take Profit fields
When using a Pending Order, you have the option of setting an expiry date on your order. Execute this instruction if required.
Click on the Place button to enter your trade. A dialogue box will appear to confirm that your trade has been executed.
Stop Loss Order versus Stop Limit Order
A Stop Loss Order is a computer-generated order to a broker’s server to buy or sell an underlying asset once it reaches a certain price point. It’s designed to limit a trader’s loss on a forex position.
A Stop Limit Order also acts in the same way but a limit is placed on the price at which the order will be executed. Two prices are specified in a Stop Limit Order. This includes the Stop price which converts the order to a sell order; and the Limit price which means the order is executed at the limit price or a better price.
In other words, for buy limit orders, the Stop Order is executed either at the pre-determined price or a lower price. This means traders are guaranteed the price they set or less. In contrast, for sell limit orders, the order is executed at the limit price or higher.
Different ways Stop instructions protect forex traders
Stop Loss Orders are designed to protect traders from incurring significant losses. At the same time, these orders are not meant to create losses because they are executed prematurely. Your Stop Loss Order strategy should facilitate your trading strategy by minimising slippage and simplify a timely exit from the position.
Depending on your trading strategy, you will approach setting Stop Loss Orders in one of few ways:
When traders set a Stop Loss Order at a static price, they do not change the order until the position hits the Stop (or Limit) price. It’s the easiest Stop Loss strategy to follow and suitable for beginners. It’s a simple case of setting your Stop Loss Order based on a risk-to-reward ratio; getting in and getting out and incurring the least amount of risk.
Static Stops based on Indicators
This forex strategy involves taking Static Stops a step further. In this case, the Static Stop distance is determined using a technical indicator such as the Average True Range (ATR).
ATR is an indicator used in more volatile trading conditions that shows traders how much an underlying asset typically moves on average during a specified period of time. The indicator is particularly useful for intraday traders and helps confirm when it’s the right time to enter and exit a trade.
Trailing Stops are ordinary Stop Loss Orders but they are slightly more flexible. This is because it follows price movements of a currency pair without traders needing to be manually reset the Stop price. The trade is only closed if the price of the currency pair suddenly changes and moves in the wrong direction.
Trailing Stops allow traders to safeguard what they have already gained in profits on a long or short position by allowing the trade to remain open. This means the position will continue to capitalise on gains for as long as the price of the underlying asset moves in the right direction.
Trailing Stops are a common method used to determine an appropriate exit point. The Trailing Stop consistently maintains a Stop Loss Order on a trade at the exact percentage pre-determined by the trader.
The difference is the Trailing Stop does not stop the trade when the actual price reaches the pre-determined price, only when it breaks through the price barrier.
The Stop Loss Order is continuously adjusted to accommodate fluctuations in the market price but is always maintained at the same percentage below or above the market price. This approach is usually automated but Trailing Stops on occasion are manually set each time.
A percentage stop uses a pre-determined portion of the funds in a trader’s account. In other words, the portion or percentage that a trader is willing to risk on an open position. It could be as low as 2% or as high as 15% of the trader’s account.
Traders use this method to determine the percentage of risk they are willing to take on and then use the size of their position to calculate how far they set the Stop away from their entry point.
If you are trading on volatility or in volatile trading conditions, you need to know how much a currency pair tends to move so you can set the correct Stop Loss Order. This is important to avoid a trade closing prematurely due to random price fluctuations.
Traders use technical charts to analyse support and resistance levels to help them find the point of exit on a position and set their Stop Loss Order. Where a trendline reveals two possible Stop Loss points, traders use their discretion to choose one or the other.
Setting a Time Stop is where traders select a pre-determined time within to trade. This could be a matter of hours, days and weeks or longer. Time Stops are more commonly used by intraday traders who open and close positions multiple times in a day but always close out positions at the end of the trading day.
Forex Trading Africa Disclaimer
Trading forex is associated with high risks and can lead to investors and traders losing a significant amount of money. The information in this article should only be used to educate yourself on how forex trading works and the pros and cons of trading on support and resistance levels.
Pay due caution to the risks involved in forex trading and take the necessary precautions to avoid losing capital on forex positions.