What's a Forex Stop Loss? and Factors to Consider When Setting Forex Stop Loss Orders
Stop Loss is a type of order placed after opening a forex trade that is meant to cut losses if the market moves against your open trade position.
Stop Loss order is a predetermined point of exiting a losing trade transaction and it is meant to control losses.
A stop loss is an order placed with your forex broker that will automatically close your open forex trade when the currency you are trading reaches a predetermined price. When the set level for this stop loss order is reached, your open forex trade transaction is liquidated.
These stop loss orders are designed to limit the amount of money that a trader can lose when trading the Market: by exiting the open trade if a particular price that is against the open trade position is reached.
For example, one might buy EURUSD at 1.3700, and place a stop loss at 1.3665. If the price goes against you and reaches 1.3650, the stop loss order will be filled and the open trade transaction will be liquidated thereby limiting the loss to 35 points (pips).
Regardless of what you may be told by other traders, there is no question about whether these stoploss orders should or should not be used - stoploss orders should always be used.
One of the most difficult things in Forex is setting these stop loss orders. Set the stop loss order too close to your entry price and you're liable to exit the open forex trade due to random market volatility. Place the stop loss order too far away and if you are on wrong side of the trend, then a small loss could turn into a large one.
Skeptics will point out several disadvantages of these stoploss orders: that by placing them you're guaranteeing that should your open forex trade position move in wrong direction, you will end up selling at lower prices, not higher.
The critics will also argue that in setting stops you are vulnerable to exit a transaction just before the market moves in your favor. Most investors have had the experience of setting these stop loss orders and then seeing the forex price retrace to that level, or just below it, and then go in direction of their original market trend analysis. What may have been a profitable trade position instead turns into a loss.
Experienced traders always use stops as they are an important part of the discipline required to succeed because stop loss orders can prevent a small loss from becoming a large one. What's more is that by diligently setting these stop loss orders whenever you enter a forex trade position, you end up making this important decision at point in time when you are most objective about what's really happening with forex market, this is because the most objective technical analysis is done before opening a forex trade. After entering the market an investor will tend to interpret the market differently because they have a bias towards one side, the direction of their forex trade analysis.
Unexpected news can come out of the blue and dramatically affect the currency price: this is why it's so important to have a stop loss order. Its best to cut losses early when a forex trade position is going against you, it is better to cut your forex losses immediately rather than waiting it to become a big one. Again, if you set your stops when you are entering a trade, then that is when you are most objective.
A key question is exactly where to place this stop loss order. In other words how far should you place this stop loss order below your purchase price? Many traders will tell you to set predetermined - maximum acceptable loss, an amount based on your forex account balance rather than using forex technical indicators to analyze where to set thee stop orders for the currency pair in question.
Professional money managers advice that you should not lose more than 2% of your forex account equity on any one single forex trade. If you have $50,000 in capital, then that would mean the maximum loss you should set for any one single forex trade transaction is $1,000.
If you bought 1 standard forex lot of a currency pair, then you would limit your risk to no more than $1,000. In that case you would set your stop loss at 100 pips (points) and would have $49,000 in your forex trading account left if you exited the position at the maximum loss allowed. The topic of Forex risk management is wide and it is covered under money management topics.
Factors to Consider When Setting Stop Loss Orders
Most important question is how close or how far this stop-loss order should be from the price where you entered the forex trade position. Where you set the stop loss order will depend on several factors:
Since there are no rules cast in stone as to where you should place these stop-loss order levels on a forex chart, we follow general guidelines used to help place these stop loss order levels correctly.
Some of the general guidelines used to set stop loss orders are:
1. Risk - How much is one willing to lose on a single forex trade transaction. The general rule is that a trader should never lose more than 2 percent of the total forex account capital on any one single trade transaction.
2. Volatility - this refers to the daily price range movement of a currency pair. If a currency pair routinely moves up and down in a range of 100 pips or more over the course of the day, then you cannot set a tight stop loss. If you do, you'll be taken out of the trade position by the normal market volatility.
3. Risk to reward ratio - this is the measure of potential reward to risk. If the market conditions are favorable then it's possible to comfortably give your open forex trade more room. However, if the forex market is too choppy it then becomes too risky to open a forex trade without a tight stop loss - then do not make the forex trade at all. The risk to reward ratio is not in your favor & even setting tight stops will not guarantee profitable results. It would be wiser to look for a better forex trade position to next time.
4. Position size - if the forex trade size opened is too big then even the smallest decimal price movement will be fairly large in percentage terms. This means that you have to set a tight stop loss which may be taken out more easily. In most cases it's better to adjust to a smaller forex trade position size so as to give your forex trade more space for fluctuation, thereby setting a reasonable stop loss level for this stop loss order while at same time reducing the risk of your stop loss order being taken out quickly by market volatility.
5. Account Capital - If your forex account is under-capitalized then you will not be able to set your stop loss order levels accordingly, because you will have a large amount of money in a single forex trade position which will force you to set very tight stops. If this is case, you should think seriously about whether you've enough capital to trade Forex in the first place.
6. Market conditions - If the forex price is trending upward, a tight stop might not be necessary. If on the other hand the price is choppy & has no clear direction then you should use a tight stop or not open any forex trades at all.
7. Chart Time frame - the bigger the forex chart time frame you use, the bigger the stop loss level should be. If you were a scalper your stops would be tighter than if you were a day trader or a swing trader. This is because if you are using longer forex chart time-frames & you figure out the forex price will be move upwards it does not make sense to set a very tight stop because if the currency swings a little your open forex trade stop loss order level will be hit.
The method of setting a stop loss order that you choose will greatly depend on what type of forex trader you're. Most oftenly used method to determine where to set stop loss orders is - resistance and support levels. These levels give good points for setting these stop loss orders as they are the most reliable because these levels provides areas where forex price is not likely to move past or beyond these points, because the support and resistance levels will not be hit many times many traders use these levels to set stop loss orders just above resistance levels or set stop loss orders just below the support levels.
The technique of how to set these stops that you choose should also follow the guidelines explained above, even if not all of these that apply to your forex trading strategy.
