In forex trading, everybody wants to keep the wins and stop the losses. A stop loss order is a good tool to stop losses, especially for novice traders.
What is a stop loss?
A stop loss is an order type used in forex trading designed to limit losses from a trade. It is also known as a ‘stop order’ or ‘stop-market order’.
The order will trigger a trade to be closed at a loss. Specifically, it is an order from the trader to their trading company or broker to execute a trade when the market price is at a specific price level, which is a less favourable price than the trader’s entry price.
No forex trader desires a loss but since some losing trades are inevitable in trading, it is better to keep the losses small and reduce risk exposure.
Stop loss forex example
We will offer two examples, one for a trade that is long the forex market and one for a trade that is short the forex market.
Stop loss on a long forex position
Market order is placed to BUY 5 lots of EUR/USD at 1.1750
Stop loss order is placed to SELL 5 lots of EUR/USD at 1.1730
The stop price is 1.1730 and the stop loss is worth 20 pips.
On a trade of 5 lots (500,000) - each pip is worth $50 - so the stop loss is worth 20pips x $50 = $1000
Stop loss on short forex position
Market order is placed to SELL 1 lot of USD/JPY at 109.70
Stop loss order is placed to BUY 1 lot of USD/JPY at 110
The stop price is at 110 and the stop loss is 30-pips wide.
On one lot of USD/JPY, each pip is worth $9 so the stop loss is worth $270
How a stop order works
It’s important to understand that a stop loss order is an order type known as a ‘stop order’. The way a stop or executes is different other order types like a limit order, which is used in a take profit order. Where as limit orders execute at the limit-price or better, a stop order executes at the next best available market price after the stop order is triggered.
For example: You buy GBP/USD at 1.3110 and set a stop loss at 1.3100. If there is nobody willing to accept your sell trade at 1.3100 - perhaps because the market is gapping after an economic news release - then your stop will not be triggered at 1.3100. It will be triggered at the end of the price cap at the next market price.
Is stop loss a good idea?
The best forex traders will decide before buying a currency pair, where they will sell it in case the trade becomes a loss. Equally, they know where they would buy it back at a loss if they went short a forex pair.
Using a stop loss is just an automated way of making sure you exit the trade as you planned. The same argument can be made for ‘take profit’ limit orders, which make sure you exit a winning trade as planned.
The major benefit of a stop loss is knowing that you have an order sitting, ready and waiting to cut your losses, without you needing to monitor the price movement all day long. This is especially helpful for part-time traders, which most new traders tend to start as.
How to set a stop loss in forex trading
How to place a stop loss order when trading is one of the most common questions asked by a novice trader. The size of your stop loss comes down to risk management and position sizing. Here is a step-by-step guide to finding the best stop loss strategy for any trading system.
- Determine what price would mean your trade idea is wrong - Set the stop loss order (SL) here
- Determine what price level the market could move to if you are right - set the take profit order (TP) here
- Choose an entry price that makes sure the reward of hitting the TP level is worth the risk of hitting the SL. Trading books often cite a 2:1 risk to reward ratio.
- The number of pips you are risking is the difference between your entry and stop loss
- Choose a trade size that means you are risking 2% or less of your account on the trade. If you can afford to risk $500 and your stop loss is 50 pips, you can place a trade for 5 lots.
It is quite possible to use a very simple stop loss system like using a 10 pip stop loss for every trade. However, this makes the trade less able to adjust trading parameters according to volatility.
Stop loss calculator
It’s not typically necessary to use a stop loss calculator to calculate the stop-loss price or stop-loss value because modern online trading platform will have it integrated. However when researching and first getting familiar with using a stop loss, a stop loss calculator like this example on babypips.com can be very handy.
What is a guaranteed stop?
A guaranteed stop loss is a type of stop loss order where a trader will arrange with their broker, often for a fee, to guarantee the stop loss will be triggered at the pre-agreed price. Using a guaranteed stop loss to some degree mitigates the risk that the stop order will be triggered at an undesirable price in volatile market conditions.
Why a stop loss is important in forex
A common argument against stop losses is that it means you a prematurely taken out of a trade. New traders will recite an experience of seeing a price drop 2 pips past their stop loss and reversing back to whether they would have taken profits. Clearly this is a frustrating experience - but there are three better answers to not using a stop loss.
A) It might be where you are placing the stop loss is the issue, rather than using the stop loss.
B) Norrowly missign out is easily worth avoiding the inevitable experience of a much bigger loss when eventually the price does not quickly reverse from near your stop-price.
C) You can close out your postion using stop orders in parts using an average method stop loss- meaning some of your postion could remain open to take advantage in case the trend quickly changes.