Using Stop Loss Orders in Forex Trading

Market movements can be unpredictable, and the stop loss is one of the few mechanisms that traders have to protect against excessive losses in the forex market. Stop losses in forex come in different forms and methods of application. This article will outline these various forms including static stops and trailing stops, as well as highlighting the importance of stop losses in forex trading.

WHAT IS A STOP LOSS？

A forex stop loss is a function offered by brokers to limit losses in volatile markets moving in a contrary direction to the initial trade. This function is implemented by setting a stop loss level, a specified amount of pips away from the entry price. A stop loss can be attached to long or short trades making it a useful tool for any forex trading strategy.

WHY IS A STOP LOSS ORDER IMPORTANT？

Stops are critical for a multitude of reasons, but it can really be boiled down to one thing: we can never see the future. Regardless of how strong the setup might be, or how much information might be pointing in the same direction – future currency prices are unknown to the market, and each trade is a risk.

In the DailyFX Traits of Successful Traders research, this was a key finding – traders actually do win in many currency pairs the majority of the time. The chart below shows some of the more common pairings.

FOREX STOP LOSS STRATEGIES

Below are five strategies to apply in your forex trading when placing stop loss orders:

1. Setting Static Stops

Traders can set forex stops at a static price with the anticipation of allocating the stop-loss, and not moving or changing the stop until the trade either hits the stop or limit price. The ease of this stop mechanism is its simplicity, and the ability for traders to ensure that they are looking for a minimum one-to-one risk-to-reward ratio.

For example, lets consider a swing-trader in California that is initiating positions during the Asian session; with the anticipation that volatility during the European or US sessions would be affecting their trades the most.

This trader wants to give their trades enough room to work, without giving up too much equity in the event that they are wrong, so they set a static stop of 50 pips on every position that they trigger. They want to set a profit target at least as large as the stop distance, so every limit order is set for a minimum of 50 pips. If the trader wanted to set a one-to-two risk-to-reward ratio on every entry, they can simply set a static stop at 50 pips, and a static limit at 100 pips for every trade that they initiate.

2. Static Stops based on Indicators

Some traders take static stops a step further, and they base the static stop distance on an indicator such as Average True Range. The primary benefit behind this is that traders are using actual market information to assist in setting that stop.

So, if a trader is setting a static 50 pip stop loss with a static 100 pip limit as in the previous example – what does that 50 pip stop mean in a volatile market, and what does that 50 pip stop mean in a quiet market？

If the market is quiet, 50 pips can be a large move and if the market is volatile, those same 50 pips can be looked at as a small move. Using an indicator like average true range, or pivot points, or price swings can allow traders to use recent market information to more accurately analyze their risk management options.