How to Use a Stop-Loss and a Take-Profit in Forex Trading
Reading time: 9 minutes
This article will provide an explanation of how to use a stop loss and a take profit when trading Forex (FX). The article will cover how to place stop-losses in Forex, it will provide some examples of placing stop-losses when using certain trading strategies, how to place profit targets, and more!
It is important to know how to set a stop-loss and a take-profit in Forex, but what do stop-losses and take-profits actually represent?
These two forms are the most significant elements of trade management. A stop-loss is determined as an order that you send to your broker, instructing them to limit the losses on a particular open position or trade. As for the take-profit or target price, it is an order that you send to your broker, notifying them to close your position or trade when a certain price reaches a specified price level in profit. In this article, we will explore how to use stop-loss and take-profit orders appropriately in FX.
How to Place Stop-Losses in Forex
The first thing a trader should consider is that the stop-loss must be placed at a logical level. This means a level that will both inform the trader when their trade signal is no longer valid, and that actually makes sense in the surrounding market structure. There are several tips on how to exit a trade in the right way. The first one is to let the market hit the predefined stop-loss that you placed when you entered the trade. Another method is to exit manually, because the price action has generated a signal against your position.
Knowing how to calculate stop-loss and take-profit in Forex is important, but it is crucial to mention that exits can be end up being purely emotion-based. For instance, you could end up manually closing a trade just because you think the market is going to hit your stop-loss. In this case, you feel emotional, as the market is moving against your position, despite no price action based reason to exit manually being present.
The ultimate purpose of the stop-loss is to help a trader stay in a trade until the trade setup, and the original near-term directional bias are no longer valid. The aim of a professional Forex trader when placing a stop-loss is to place the stop at a level that grants the trade room to move in the trader's favour.
Essentially, when you are identifying the best place to put your stop-loss, you should think about the closest logical level that the market would have to hit to actually prove your trade signal wrong. Therefore, stop-loss traders want to give the market room to breathe, and to also keep the stop-loss close enough to be able to exit the trade as soon as it is possible, if the market goes against them. This one of the key rules of how to use stop-loss and take-profit in Forex trading.
A lot of traders cut themselves short by placing their stop-loss too close to their entry point, merely because they want to trade a bigger position size. But the trap here is that when you place your stop too close, you are actually invalidating your trading edge, as you need to place your stop-loss based on your trading signal and the current market conditions, and not on the basis of how much money you anticipate to make.
Therefore, your assignment is to define your stop-loss placement prior to identifying your position size. In addition, your stop-loss placement should be determined by logic. Do not allow greed to lead you to losses.
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Examples of Placing Stop-Loss Strategies
The first strategy is known as the 'Pin Bar Trading Strategy Stop-loss Placement'. The most logical place to put your stop-loss on a pin bar setup is usually beyond the high or low of the pin bar tail.
The second strategy example is the 'Inside Bar Trading Strategy Stop-loss Placement'. Here, the most logical place to put your stop-loss is on an inside bar setup that is solely beyond the mother bar high or low.
The third stop-loss/take-profit strategy example is the 'Counter-trend Price Action Trade Setup Stop-loss Placement'. For a counter-trend trade setup, your task is to place the stop-loss just beyond either the high or the low made by the setup that indicates a potential trend change.
The next example strategy is the 'Trade Range Stop Placement'. Every trader often sees high-probability price action setups forming at the boundary of a concrete trading range. In such cases, traders may want to place their stop-loss just over the trading range boundary, or on the high or low of the setup being traded.
Consider this when learning how to use stop-loss and take-profit in FX. For instance, if we had a pin bar setup at the top of a trading range that was precisely under the trading range resistance, we would place our stop a little bit higher, just outside the resistance of the trading range, rather than just over the pin bar high.
The next example strategy is 'Stop Placement in a Trending Market. When a trending market either pulls back or retraces to a level within the trend, we commonly have two options. The first option is that we can place the stop-loss just over the high or low of the pattern, or we can use the level, and place our stop just under it. Finally, we have come to the 'Trending Market Breakout Play Stop Placement'. This will expand your knowledge about take-profit and stop-loss in Forex. In a trending market, we will frequently see the market pause and consolidate in a sideways manner after the trend makes a powerful move.
Such consolidation periods mostly give rise to large breakouts in the direction of the trend, and these breakout trades can potentially be lucrative for traders. There are generally two options for stop placement on a breakout trade with the trend. You can either place your stop-loss near the 50% level of the consolidation range, or on the other side of the price action setup.
How to Place Profit Targets
Frankly speaking, the most feasible approach of how to use stop-loss and take-profit in Forex is perhaps the most emotionally and technically complicated aspect of Forex trading. The trick is to exit a trade when you have a respectable profit, rather than waiting for the market to come crashing back against you, and then exiting out of fear. The difficulty here is that you will not to want to exit a trade when it is in profit and moving in your favour, as it feels like the trade will continue in that direction.
The irony is that not exiting the moment the trade is significantly in your favour usually means that you will make an emotional exit, as the trade comes crashing back against your current position. Therefore, your focus when using the stop-loss and the take-profit in Forex should be to take respectable profits, or a 1:2 risk/reward ratio or greater when they are available - unless you have predefined prior to entering, that you will try to let the trade run further.
What is the General Profit Target Placement Theory?
After identifying the most logical placement for our stop-loss, our attention should then shift to finding a logical profit target placement, as well as a risk/reward ratio. It is important to be sure a decent risk to reward ratio is viable on a trade, otherwise it is definitely not worth taking. Therefore, you have to identify the most logical place for your stop-loss, and then proceed to define the most logical place for your take-profit.
If after doing this, there is a decent risk/reward ratio possible on the trade, this trade is probably worth taking.
Nonetheless, you have to be honest with yourself in such a situation - do not ignore key market levels or apparent obstacles that are in your way in terms of reaching a satisfactory risk/reward ratio, simply because you want to enter a trade. Also, don't forget to use the correct stop-loss/take-profit ratio. You have to analyse the general market conditions and structure, resistance and support levels, the main turning points in the market, bar lows and highs, and other important elements.
Try to define whether there is some key level that would make a logical take-profit point, or whether there is some key level obstructing the trade's path to making an adequate profit.
Every trade is basically a business deal. It is essential to weigh the risk and the reward from the deal, and then to decide whether it is worth taking or not. In Forex trading, you should consider the risk of the trade, as well as the potential reward, and if it's realistically practical to obtain it according to the surrounding market structure. To trade more profitably, it is a prudent decision to use stop-loss and take-profit in Forex.
If you would like to learn more about stop losses in Forex, make sure to read the following articles:
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