What is stop-loss in Forex trading and how to set it

Forex stop-loss

It goes without saying that when Forex traders begin to learn to trade, one of the foremost goals is to find the best possible trading system for entering positions. If a particular trading system is good enough, all the other factors such as trade management or risk management can lose importance to you. As a result, you are less likely to be interested in protecting your trades by using a Forex stop-loss.

If our trades are moving in our direction and we are making money, all of these other aspects might seem irrelevant. All we have to do is simply find a system that works most of the time, and then the majority of Forex traders discover that they can figure everything else out as they go along.

We do not intend to dishearten you, but they reality is much different. What we described above is the idea of perfect trading. Unfortunately this is not realistic. There is no FX trading system that will undoubtedly win the most of the time with a win rate of 99%. Therefore, without risk, money and trade management, most novices will be unable to reach their goals and fulfill their aspirations until they make some radical changes to their approach.

Traders have to practice wise risk management, so that when they are wrong, losses can be minimised. Conversely, when traders are right, profits can be maximised. As a consequence, realising that risk management should be practised is one thing, but actually doing it is a whole different matter. That is why we have prepared this article for you in order to explain what is stop-loss in Forex trading, before explaining how to set them up.

What are stops and why they are important?

The first logical question to answer is - what does a stop-loss in the foreign exchange market represent? 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 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 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.

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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 give 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 incident 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, he 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 be also based on indicators and you should consider that if you want to learn how to use 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 an 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. Thus, it is important know how to set stop-loss in Forex trading.

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Stop-loss: trailing stops

Using static stops can bring considerable benefits to 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 EUR/USD 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 look at adjusting his stop up to 1.3200 from the starting stop value of 1.3150.

A trailing stop actually moves the stop-loss Forex to his entry price or break-even price, so that if EUR/USD 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 this trade, and he can look to place that risk in another FX trade opportunity, or alternatively keep that risk amount off the table and just be happy with a protected position in the long EUR/USD trade.

It would be a mistake not to mention 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 the trade moves in the trader's favour. Consequently, referring to the example given above, if EUR/USD moves up to 1.3201 from the starting entry of 1.3200, the stop will be adjusted up to 1.3151.

Except for the dynamic trailing stops, we should exemplify manual trailing stops. For the traders that want the most control, stops can be moved manually by the trader as the position moves in his 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 stop-loss in Forex.

Conclusion

We hope we have addressed the question - what is stop-loss in Forex? It's not hard to see why a stop-loss is crucial. Most 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 careers. You should now be capable of distinguishing where to set a stop-loss in your future trades.