A ‘stop loss’ can be both your greatest savior and at times your greatest enemy when trading Forex. It can protect your account from capital losses caused by a sudden change in market direction, while equally it can take you out of a position and limit your gains.
Making use of them however an integral part of successful trading. Many traders however fail to understand how these levels can be used most effectively.
The Stop Loss is an order set with your Forex broker where you agree to cut your losses on a trade that moves against you. It is your risk or to put it another way, the amount you are prepared to risk on a trading outcome. While novice traders focus on what how much they stand to profit, knowing what you stand to lose is arguably more important as it defines your risk.
Knowing what Stop Loss is and knowing how to use it effectively are two separate things. Here we take a look at some strategies for making effective use of a stop loss.
Trading Tight Stops
Stop loss levels are designed to limit your risk on a trading position. They represent the amount that you are prepared to stake in order to find out if your trading prediction is correct. Therefore your risk should in most instances, be tied in with your expectation for profit.
Here’s an example. If you are targeting 100 pips of profit, then it stands to reason that you are unlikely to want to risk 200 pips to find this out.
Traders are often cautioned when entering a position to control their risks. This is often interpreted as using ‘tight’ stops. In the example above, placing your stop 50 pips from the current market level would keep the stop tight to the market price and seem to offer a good risk to reward ratio. The trade would also offer a good level of risk to reward with the potential of earning 100 pips.
If you accept that we can only ever attempt to predict the random nature of market movements, then we should approach the issue of where to place our stop with risk in our favor.
For this reason we want to keep our stop levels balanced to our risk and tight to the market price. However Forex markets are volatile and often behave erratically within the context of broader moves. Consequently you need to be aware of keeping your stop level too tight. While this may reduce risk, it can prove counterproductive.
Rather than reduce your risk, using a stop level too close to the market price can it can actually invite risk. This is because you expose your position to being ejected on the next sudden spike.
Risks of Big Stops
Given the above it could be viewed that the answer is to place a larger stop.This in theory should prevent a position from being taken out by day to day market volatility.
Logic dictates that with fewer trades having the potential for being taken out by price spikes, trading performance and therefore profitability on the Forex account should naturally improve.
However it is important to understand that a larger stop actually increases risk.
By situating your stop further away from the current price action you actually need a greater tolerance to risk. This is because if the market moves against your position, you stand to lose more of your account.
Think about it. Trading with no stop is actually accepting total risk of your account. This of course must be avoided. However it serves to illustrate that the more money you risk as your stop, the more risk your account is taking on should the market reverse.
To achieve Forex success, you need to understand is that by pushing your stop further out, you end up making the risk to reward on a trade more unfavorable.
Here is another stop loss Forex example.
If you target 100 pips profit with a 50 pip stop, risk is 2:1 (2 units of profit for 1 unit of risk). The same trade with a 100 pip stop is 1:1.
When picking trade set ups you also need to factor this important ratio in. This is implicitly linked in with your win rate.
How To Calculate A Stop Loss in Forex
Stop levels can be defined by Fibonacci, pivot points, support and resistance or simply fixed numerical or percentage levels. However it is important to understand that there is no golden rule for where you should place your stop. No strategy for Stop levels will work all of the time. There will always be times when the market trips you out.
There are however a number of steps that you can take to optimise your use of stop levels.
Take time to look at your strategy, attitude to risk and most importantly, the risk to reward on your positions. These are the most obvious areas which will help you to decide on the best stop loss levels to place on your account.
One approach is to use a percentage risk approach to your stop positioning. This provides a dynamic and fixed risk approach to trading. Risking a set percentage of your account, generally no more than 2-3% per position will help to limit your financial risk.
A risk calculator will allow you to work out the number of pips ‘risked’ for your stop to ensure you are trading optimally for your account size. All you then need to do is work out a suitable support or resistance level where you can place your stop within the pip range available.
This provides a simple and effect use of stops which can be customised as the prices on your positions move. You can dynamically move your stops to further enhance your risk management. This will have the effect of ‘locking in profits’ as the market moves in your favor. This will allow you to protect the balance of your account.
Trailing Stop Losses
A final note on the use of trailing stops. The trailing stop loss in Forex is often seen as the answer to the ‘stop’ problem by new traders. It does of course make sense in follow the market up and it does provide some protection to your funds.
The issue with trailing stop levels however is that they should not be relied upon as a risk safeguard solution.
By their very nature trailed stops only allow you to move arbitrary number of pips and do not respect potential technical levels of support and resistance. This makes them prone to pullbacks and whipsaw movements which can actually accentuate the problem of being taken out of the market prematurely.
What they do offer however is a simple way to trail the market if you are unable to monitor your open positions and are keen to lock in profits. Just be sure to give your trade room to breathe.