Forex stop-loss strategy

Forex trading stop-loss strategy

In Forex, no one can survive without decent risk management and money management. Fortunately, stop-loss orders are here to help you. With them, you can protect your trade as well as your trading decisions by removing negative emotions like greed or fear and the unpleasant consequences they deliver. You already know that a stop-loss is an order that you place with your FX 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 your yourself.

A stop-loss can be implemented in many ways in Forex, so it is important to develop a good and feasible Forex stop-loss strategy that will meet your needs. In this article we will provide you with the information you need to choose the best stop-loss strategy that can be used to minimise risk and thus maximise gains.

Stop-loss strategy: inside bar and pin bar

We will exemplify inside bar and pin bar trading strategies, so 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 to 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 bullish pin bar. Therefore, if 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.

Comparatively to 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 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 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 Forex - a trader has a less of a buffer between the stop-loss and 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.

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''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 place your stop-loss and then let the market run its course. Let us see what the advantages are of this approach.

'Set and Forget' stop-loss strategy Forex trading 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 then let the market do the rest. The last advantage is that it is exceptionally simple to implement and requires only a one time action.

This strategy does have specific disadvantages. The biggest - and often the most costly - drawback of this strategy is the maximum allowable risk that is present from the beginning to finish. If 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 Forex best 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 market entry. The following day, the market finishes a little bit higher than your entry. Thereby, instead of moving to break even or close to it - 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 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 of this Forex strategy 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 thus 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. That is owing to using market highs and lows in order to protect the stop-loss as opposed to an arbitrary level. An additional plus of applying 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 work. 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. Most 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 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 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. Thereby, this would mitigate the stop-loss from 100 pips to 50 pips.

Conclusion

It is highly recommended to use a stop-loss. As soon as you have mastered the ability to determine key levels, define price action strategies, use an appropriate risk-reward ratio and use confluence to your advantage, a proper FX stop-loss strategy is what is necessary to take your trading to the next level. You need to find the best Forex stop-loss strategy that is suitable for you.

Read also:

https://admiralmarkets.com/education/articles/forex-basics/forex-guaranteed-stop-loss-vs-non-guaranteed