What Is Stop-Loss In Forex Trading?
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This article will explore various topics associated with stop-losses including: what is a stop loss? How do you set a stop-loss? and Why are stop-losses important? This article will also provide traders with some excellent strategies they can use with Forex stop-losses, to ensure they are getting the most out of their trading experience.
What is a Stop-loss?
A stop-loss is an order that you place with your FX broker and CFD Broker in order to sell a security when it reaches a particular price. A stop-loss order is developed to reduce a trader's loss on a position in a security. It is good to have this tool at times when you are not able to sit in front of the computer and monitor yourself. This article will explain why the stop-loss is necessary, how to set it up, as well as, some examples of stop-loss strategies that traders can use.
Why Are Stops Important?
The first logical question to answer is - what does a stop-loss in the foreign exchange market represent? To recap, a stop-loss is an order placed with your broker to sell a security when it reaches a specific price. Furthermore, a stop-loss order is designed to mitigate an investor's loss on a position in a security. Even though most traders associate stop-loss orders with a long position, it can also be applied for a short position.
A stop-loss order eliminates emotions that can impact trading decisions. This can be especially handy when one is not able to watch the position. Stop-loss in Forex is critical for a lot of reasons. However, there is one simple reason that stands out - no one can predict the exact future of the Forex market. It does not matter how strong a setup may be, or how much information might be pointing to a particular trend.
Future prices are unknown to the market and every trade entered is a risk. FX traders may win more than half the time with most of the common currency pairings, but their money management can be so poor that they still lose money. Incorrect money management can lead to unpleasant consequences. To prevent this, one should know how to calculate stop-loss in Forex.
It's easy to see how making use of stop loss orders may help market participants manage their trading psychology. Through stop loss orders, traders may eliminate the fear of the unknown and manage unwanted risks on any given position. More importantly, a simple stop loss setup may help traders control fear and anxiety when placing an order. This ability to stay level-headed in the face of pressure is necessary if one desires to have long-term success in the market.
You can see how Paul Wallace, experienced trader, uses psychological stop losses in this free webinar.
Stop-Loss: Setting Static Stops
Forex traders can establish stops at a static price with the expectation of allocating the stop-loss, and not moving or changing the stop until the trade hits the stop or limit price. In addition, the ease of this stop mechanism is because of its simplicity, and the ability for traders to specify that they are seeking a minimum 1:1 risk to reward ratio.
We will now provide an example of how to use stop-loss in Forex. Imagine a swing-trader in Los Angeles that is initiating positions during the Asian session, with the expectation that volatility during the European or North American sessions would be influencing his trades the most. This trader wishes to give his trades enough room to work, without giving up too much equity in the instance that they are wrong.
So they set a static stop of 50 pips on each position that they trigger. As a result, they want to set a take-profit at least as large as the stop distance, so each limit order is set for a minimum of 50 pips. If the trader wanted to set a 1:2 risk to reward ratio on each entry, they can simply set a static stop at 50 pips, as well as a static limit at 100 pips for every trade that they start.
Static stops can also be based on indicators, and you should consider that if you want to learn how to use the stop-loss in Forex trading. Some FX traders take static stops a step further, and they base the static stop distance on a technical indicator, such as the Average True Range. Additionally, the key benefit behind this is that FX traders are using actual market information to help set that stop.
In the previous example, we had a static 50 pips stop with a static 100 pip limit. But what does that 50 pip stop mean in a volatile market, and in a quiet market? In a quiet market, 50 pips can be a large move. If the market is volatile, those 50 pips can be looked at as a small move. Moreover, using an indicator like the Average True Range, price swings, or even pivot points can enable Forex traders to use recent market information in an effort to more accurately analyse their risk management options. Therefore, it is important to know how to set the stop-loss in Forex trading.
Stop-Loss: Trailing Stops
Using static stops can bring considerable benefits to a new trader's approach - but other FX traders have taken the concept of stops a step further in order to concentrate on maximising their money management. Trailing stops are stops that will be adjusted as the trade moves in the trader's favour, to further diminish the downside risk of being wrong in a trade.
Imagine that a trader took a long position on the EURUSD currency pair at 1.3200, with a pip stop at 1.3150, and a 100 pip limit at 1.3300. If the trade moves up to 1.3250, the trader may consider adjusting their stop up to 1.3200 from the starting stop value of 1.3150. A trailing stop actually moves the stop-loss to their entry price or break-even price, so that if the EUR/USD currency pair reverses, and then moves against the trader, at least they will protect the gains made from their original position.
This break-even stop permits the trader to remove the initial risk in their trade, and they can make the decision to place that risk in another FX trade opportunity, or alternatively keep that risk amount off the table entirely, and settle with a protected position in the long EUR/USD trade. It would be a mistake not to mention the dynamic trailing stop-loss in Forex trading. There are many types of trailing stops, and the easiest one to implement is the dynamic trailing stop.
With it, the stop will be adjusted for every 1 pip that the trade moves in the trader's favour. Consequently, referring to the example given above, if the EUR/USD currency pair moves up to 1.3201 from the starting entry of 1.3200, the stop will be adjusted up to 1.3151.
For traders that want the most control, stops can be moved manually by the trader as the position moves in their favour. For example, this may be quite useful for traders whose strategies concentrate on trends or fast moving markets, as price action plays a key part in their overall trading approach. Such traders must know how to set up a stop-loss in Forex.
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It is highly recommended to use a stop loss strategy in Forex trading. As soon as you have mastered the ability to determine key levels, you are able to define price action strategies, you can effectively use an appropriate risk-reward ratio, and you are able to use confluence to your advantage, an effective FX stop-loss strategy is what is necessary in taking your trading to the next level.
You need to find the best Forex stop-loss strategy that is suitable for you. Here are a few examples of stop-loss strategies that you can use:
Stop-Loss Strategy: Inside Bar And Pin Bar
We will now discuss inside bar and pin bar trading strategies in detail, to make sure that you are familiar with them. As for the initial stop-loss placement, it depends on the trading strategy that you use. Although you may set your stop-loss in accordance with your individual preferences, there are some recommended places for a stop-loss.
As for the pin bar strategy, your stop-loss has to be placed behind the tail of the pin bar. It does not matter whether it is a bearish or a bullish pin bar. Therefore, if the price hits the stop-loss there, the pin bar trade setup will turn out to be invalid. Considering this, you should never think of price hitting the stop-loss as a bad thing. It is just the market notifying you that the pin bar setup was not strong enough.
In comparison with the pin bar strategy stop-loss placement, the inside bar Forex trading stop-loss strategy has two options on where a stop-loss can be placed. It is either behind the inside bar's high or low, or behind the mother bar's high or low. The most common and safer inside bar stop-loss placement is behind the mother bar high or low.
Again, if the price hits your stop-loss there, the inside bar trade setup becomes invalid. This placement is safer simply because you have more of a buffer between the stop-loss and the entry, which can be especially useful in choppier currency pairs, as with this buffer you may stay in the trade substantially longer.
Now it is time to clarify the second stop-loss placement for the inside bar - it is behind the inside bar's high or low. Traders can take advantage of it because this placement provides a better risk-reward ratio. However, the main pitfall is that it opens you up to being stopped out, prior to the trade setup having had a chance to actually play out in the trader's favour.
Thus, this option is the more risky of the two placements in this stop-loss strategy for Forex - a trader has less of a buffer between the stop-loss and the entry. Which stop-loss placement to use depends on your own risk tolerance, risk-reward ratio, and also which currency pairs you are trading. As you know where the stop-loss should be placed initially, we can now take a closer look at other stop-loss strategies you can apply as soon as the market starts moving in the intended direction.
''Set And Forget'' Or 'Hands Off' Stop-Loss Strategy
The second example of a good FX stop-loss strategy is ''Set and Forget'' or 'Hands Off'. The key principle couldn't be any simpler - you simply place your stop-loss and then let the market run its course. The 'Set and Forget' stop-loss strategy alleviates the chance of being stopped out too early by retaining your stop-loss at a safe distance.
Moreover, this FX stop-loss strategy assists in eliminating emotion in your trading, as it requires no interaction after it's set. As soon as you are in the trade and have your stop-loss set, you let the market do the rest. The last advantage is that it is exceptionally simple to implement and only requires a one time action.
This strategy does of course have its disadvantages. The biggest and often the most costly drawback of this strategy is the maximum allowable risk that is present from beginning to end. If you are risking a certain amount of money, you actually stand the chance of losing that sum of money from the time you enter the trade to the time you exit.
Furthermore, there is no chance to protect your capital further. The second pitfall is that using a 'Set and Forget' or 'Hands Off' stop-loss strategy can tempt you to move your stop-loss. Leaving the stop order in one place can be emotionally challenging for even the most proficient trader. Therefore, this strategy is probably not the best Forex stop-loss strategy, but it still deserves your attention.
Stop-Loss Strategy: The 50% Stop-Loss
Although this strategy involves cutting your risk in half, it does not have to be precisely half. The advantage is that we are starting to use the market to let us know how much capital to defend. Traders can use the 50% strategy on a pin bar setup. Imagine that you enter a bullish pin bar on a daily close or a market entry. The following day, the market finishes a little bit higher than your entry.
Therefore, instead of moving to break even or a close - you can now utilise the day's low to hide your stop-loss. As soon as the market closes on the second day after your entry, you are able to use the low as a place to hide the stop-loss This permits you to cut the risk by more than 50%, but still exploits a price action level that is the previous day's low. We admit that if the market breaks the low of the preceding day, you probably will no longer desire to be in this trade.
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Now we should take a look at the advantages of this stop-loss strategy Forex. The first and most beneficial one is that it cuts risk in half. For example, if you were risking $100 on a particular trade, as soon as the market starts moving in the intended direction, you could actually move to 50%, and cut your risk to $50. Furthermore, as the 50% strategy utilises a price action level, there is simply a lesser chance that the market will hit your stop-loss.
This supposes that you are using market highs and lows in order to protect the stop-loss, as opposed to an arbitrary level. An additional plus of applying a 50% Forex stop-loss strategy is that it enables the market to breathe. As a matter of fact, the 50% strategy permits some room for the market to move, and that is what is necessary for your trade setup to play out.
However, this strategy isn't perfect. The 50% strategy leaves 50% of the position at risk. This might be satisfying for some and conversely unsatisfying for others. That is where individual preference plays a significant role in deciding which FX stop-loss strategy to use. Even though the 50% strategy provides the trader with some breathing room, it still has the possibility of being stopped out prematurely.
This is even more true for currency pairs that demonstrate choppier price action, just like the JPY crosses. Market conditions play a substantial role in deciding whether this Forex trading stop-loss strategy is acceptable. For instance, if the market had closed around the low on the second day in the example given above, the 50% strategy may not have worked.
That is because you would be moving the stop-loss too close to the current market price. In a situation like this, leaving the stop-loss at the initial placement might be a more appropriate decision. More often, moving a stop-loss to 50% when trading an inside bar setup is much riskier when compared with a pin bar setup.
There is only one way this stop-loss strategy for Forex trading can be used with the inside bar. That is when the trade is taken with the initial stop-loss behind the mother's bar low or high. In fact, when the second day closes, the stop-loss can be moved behind the inside bar's high or low, provided that the market conditions are correct. The day after the inside bar actually closes, you could potentially move the stop-loss from the mother's bar high to the high of the inside bar. Therefore, this would mitigate the stop-loss from 100 pips to 50 pips.
We hope that this article has fully addressed the question - what is stop-loss in Forex?
Together with, any other questions you might have had regarding stop-loss. It's not hard to see why a stop-loss is crucial, and most professional traders know that they need to place stops. Moreover, market movements can be quite unpredictable, and a stop-loss is one of the tools that FX traders can utilise to prevent a single trade from destroying their career.
You should now be capable of distinguishing where to set a stop-loss in your future trades, and should have a good idea of the types of strategies that are available to you as well. If you'd like to learn more about Forex, or trading in general, make sure to check out our selection of articles & tutorials! Alternatively, if you'd like to learn more about stop loss trading, and related topics such as guaranteed stop loss, check out the articles below:
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.