What is a Forex Stop Loss? and Factors to Consider When Setting
Stop Loss is a type of order placed after opening a trade that is meant to cut losses if the market moves against you.
It is a predetermined point of exiting a losing transaction and it is meant to control losses.
A stop loss is an order placed with your broker that will automatically close your transaction when the currency you are trading reaches a predetermined price. When the set level is reached, your open transaction is liquidated.
These orders are designed to limit the amount of money that one can lose; by exiting the transaction if a specific price that is against the trade is reached.
For example, one might buy EURUSD at 1.3700, and place a stop loss at 1.3665. If the price goes against you and reaches 1.3650, the order will be filled and the transaction will be liquidated thereby limiting the loss to 35 points (pips).
Regardless of what you may be told by others, there is no question about whether these orders should or should not be used - they should always be used.
One of the most difficult things in Forex is setting these orders. Put the stop loss too close to your entry price and you are liable to exit the trade due to random market volatility. Place it too far away and if you are on the wrong side of the trend, then a small loss could turn into a large one.
Critics will point out several disadvantages of these orders; that by placing them you are guaranteeing that, should your open position move in the wrong direction, you will end up selling at lower prices, not higher.
The skeptics will also argue that in setting stops you are vulnerable to exit a transaction just before the market moves in your favor. Most investors have had the experience of setting a these orders and then seeing the price retrace to that level, or just below it, and then go in the direction of their original market trend analysis. What might have been a profitable position instead turns into a loss.
Experienced traders always use stops as they are an important part of the discipline required to succeed because they can prevent a small loss from becoming a large one. What's more, by diligently setting these orders whenever you enter a position, you end up making this important decision at the point in time when you are most objective about what is really happening with the market, this is because the most objective technical analysis is done before opening a transaction. After entering the market an investor will tend to analyze the market differently because they have a bias towards one side, the direction of their analysis.
Unexpected news can come out of the blue and dramatically affect the currency price; this is why it's so important to have a stop loss. Its best to cut losses early when a position is going against you, it is best to cut your losses immediately rather than waiting it to become a big one. Again, if you set your stops when you are entering a trade, then that is when you are most objective.
A key question is exactly where to place a this order. In other words, how far should you place this below your purchase price? Many traders will tell you to set a predetermined - maximum acceptable loss, an amount based on your account balance rather than use technical indicators of the currency pair in question.
Professional money managers advice that you should not lose more than 2% of your account equity on any one single currency transaction. If you have $50,000 in capital, then that would mean the maximum loss you should set for any one single transaction is $1,000.
If you bought 1 standard lot of a currency pair, then you would limit your risk to no more than $1,000. In that case you would set your stop loss at 100 pips (points) and would have $49,000 left if you exited the position at the maximum loss allowed. The topic of Forex risk management is wide and it is covered under money management topics.
Factors to Consider When Setting
The most important question is how close or how far this order should be from the price where you entered the position. Where you set will depend on several factors:
Since there are no rules set in stone as to where you should set these levels on a chart, we follow general guidelines used to help place these levels correctly.
Some of the general guidelines used are:
1. Risk - How much is one willing to lose on a single transaction. The general rule is that a trader should never lose more than 2 percent of the total account capital on any one single transaction.
2. Volatility - this refers to the daily price range of a currency pair. If a currency pair routinely moves up and down in a range of 100 pips or more over the course of the day, then you cannot set a tight stop loss. If you do, you'll be taken out of the position by the normal market volatility.
3. Risk to reward ratio - this is the measure of potential reward to risk. If the market conditions are favorable then it's possible to comfortably give your trade more room. However, if the market is too choppy it then becomes too risky to open a transaction without a tight stop then don't make the trade at all. The risk to reward is not in your favor and even setting tight stops will not guarantee profitable results. It would be wiser to look for a better position to next time.
4. Position size - if the position size opened is too big then even the smallest decimal price movement will be fairly large in percentage terms. This means that you have to set a tight stop which may be taken out more easily. In most cases its better to adjust to a smaller position size so as to give your trade more space for fluctuation, by setting a reasonable level for this order while at the same time reducing the risk.
5. Account Capital - If your account is under-capitalized then you will not be able to set your stops accordingly, because you will have a large amount of money in a single position which will force you to set very tight stops. If this is the case, you should think seriously about whether you have enough capital to trade Forex in the first place.
6. Market conditions - If the price is trending upwards, a tight stop may not be necessary. If on the other hand the price is choppy and has no clear direction then you should use a tight stop or not open any trades at all.
7. Chart Time frame - the bigger the chart time frame you use, the bigger the stop should be. If you were a scalper your stops would be tighter than if you were a day or a swing trader. This is because if you are using longer chart time frames and you determine the price will be move up it does not make sense to set a very tight stop because if the currency swings a little your order will be hit.
The method of setting that you choose will greatly depend on what type of trader you are. The most commonly used method to determine where to set is - resistance and support levels. These levels give good points for setting these orders as they are the most reliable, because the support and resistance levels will not be hit many times.
The method of how to set these stops that you choose should also follow the guidelines above, even if not all those that apply to your strategy.