Lesson 34 – Stop-Loss, A Guide for Forex Traders
Over the previous lessons, stop-losses have come up a lot in discussions, and the reason is that we really need them. Now is a good time to explain why this is the case and also how exactly they work.
As all traders realize from the moment they start trading, the forex market is extremely volatile and it is sometimes very difficult to predict where exactly it will go.
Even the most experienced traders with consistently high average returns find that the market reacts in a completely different way to what they expected.
Even with all our research and indicators directing us to one conclusion, it’s always a possibility that the market will radically shift things to another direction.
This is because there is always the possibility that an event like a new policy, speech release, rumors, or even disaster can always strike and throw prices into a completely new direction that one could not predict beforehand.
Therefore, we need to prepare ourselves for these scenarios.
A lot of beginner traders like to keep their positions that start falling into losses, hoping that the markets will change their minds and flip their positions back into profit so that they can close their positions at a profit.
Other traders get cold feet and close their positions immediately once they see their positions dip into the red.
Both of these mindsets are wrong, and not to mention, stressful.
What is needed here, is a stop-loss.
A stop-loss is an order placed with the broker to automatically close our positions when a certain price is reached.
This pretty much removes all the stress you would have from constantly monitoring your trades and sweating whilst you face the constant dilemma of cutting your losses now or hoping for a better future.
It also protects you from making a mistake and letting the trades take a wild turn and drain your entire account balance away.
Where should you place a stop loss?
As we mentioned in the previous lesson, we should calculate exactly how many pips we are comfortable losing per trade.
Bringing back to our last lesson’s example, if we stick to a 1% risk exposure to our total account balance, we should calculate how many pips would equate to that 1%.
Once we know this, we know the absolute maximum distance away from our entry point we can place our stop-loss.
However, this is not an optimal strategy to follow. We should always be placing our stop-losses at the point of invalidation.
What this basically means is that you should set your stop-loss at the point where your reasons for entering the trade in the first place are no longer valid.
To use an example, imagine we wanted to enter a trade, thinking the price will shoot upwards after hitting a support line. Instead of placing our stop loss at 100 pips below the support line, we should instead place it at around 10-15 pips lower than the support line.
Therefore, if our initial trade reason turned out to be wrong and our support line did not survive, then we would only lose 10-15 pips worth of money on that trade instead of 100.
This way, our stop-loss placement protects us from unnecessarily losing so many pips, if our trade reason had already failed long before the 100 pip drop.
If we based purely off of our previous risk management strategy and nothing else, our losses would be excessive and avoidable.
Our base risk-management strategy should be treated as the absolute maximum you are willing to lose on a trade.
It should not be set as the amount you should lose in every single trade and circumstance, especially if your point of invalidation had long been passed (as seen in our previous example).
Trailing stop-loss order
In addition to normal stop-loss orders, we can also use a trailing stop-loss.
It is a stop-loss order that “trails” or “follows” the price based on its fluctuations that move in your favor.
So, let’s say you have entered a BUY position on GBP/USD at 1.3500 with a 50 pip trailing stop-loss. If the price then moves up to 1.3600, the trailing stop-loss order will follow along with a 50 pip distance behind, moving the stop-loss up to 1.3550.
This happens every time a trade moves favorably (whether upwards on a BUY order or downwards on a SELL order), following the price along, with a lag of 50 pips (or however many pips you set it to).
This a great method to ride out successful waves in your trade and secure profits as it keeps adjusting the stop-loss upwards.
The stop-loss will only actually execute once the price moves against your favor by 50 pips.
So basically, you can ride the wave out and close your positions automatically once that wave shows signs of dipping back against you.
Moving stop-loss to the entry position
Another tactic that forex traders like to do is that, once the trade goes in their favor, they move their stop-loss to their point of entry for that trade.
This basically removes all risk exposure you have from the trade and gives you an effective guarantee of profits.
While this a great tactic in also removing the fear of losing money, it also means that you run the risk of making break-even trades rather than allowing them to really make a profit.
This is because the market can easily fluctuate and strike your stop-loss and trigger it before carrying back on to its previous trajectory.
If you hadn’t moved your stop loss upwards to the entry position, then leeway for fluctuations would have been allowed and you could later ride the upwards trajectory all the way to your profit-taking zone.
So, while it’s okay to do this from time to time, it’s usually better to place your stop-loss orders at the point of invalidation.