What's a Stop Loss? and Factors to Consider When Setting Stop Loss Orders

Stop Loss is a type of order that is set after opening a trade that's intended to cut losses if the market moves against your open position position.

Stop Loss order is a predetermined point of exiting a losing trade & it is meant to control losses.

A stop loss order is an order placed with your broker that will automatically/mechanically close out your open position position when the currency you are trading reaches a predetermined price. When the set level for this stop loss order is attained, your open trade is closed.

These stop loss orders are intended to restrict the sum of money that a trader can lose when trading the Market: by exiting the open position if a particular price that is against the open position is reached and attained.

For example, one might buy EURUSD at 1.3700, and place a stop loss at 1.3665. If the price moves against you and reaches 1.3650, the stop loss order will be filled & the open trade position will be closed thereby limiting the loss to 35 points (pips).

Regardless of what you may be told by others, there's no question about it that whether if these stoploss orders should or shouldn't be used - stoploss orders should always be used.

One of the most challenging things in FX is setting these stop loss orders. Set the stop loss order too close to your entry price and you're liable to exit the open position due to random volatility. Place the stop loss too far away and if you're on wrong side of the market trend, then a small loss could turn into a big one.

Skeptics will point out several disadvantages of these stoploss orders: that by placing them you're guaranteeing that should your open position move in the wrong direction, you will end up selling at lower prices, not higher.

The critics also will argue that in setting stop losses you are vulnerable to exit a trade transaction just before the market heads in your favor. Most investors have had the experience of setting these stop loss orders & then seeing the price retrace to that level, or just few points below it, & then go in direction of their original price trend analysis. What may have been a profitable trade position instead turns into a loss.

Experienced traders always use stop losses as they are an important part of the discipline required to succeed because stop loss orders can prevent a small loss from becoming a large one. What's more is that by diligently setting these stop loss orders whenever you enter a trade position, you end up making this important decision at point in time when you are most objective about what is really happening with market, this is because most objective analysis is carried out prior to opening a trade position. After entering the market an investor tends to interpret and analyze the market differently because they have a bias towards one side, the direction of their trade analysis.

Unexpected news can come out of nowhere and significantly affect the currency price: this is why it is so crucial to have a stop loss order. Its best to cut losses early when a trade position is going against you, it's better to cut your losses immediately rather than waiting it to become a large one. Again, if you put your stop orders when you're opening a trade transaction, then that is when you are most unbiased.

A key question is exactly where to set this stop loss order. In other words how far should you place this stop loss order below your purchase price? Many traders will tell you to set pre-determined - maximum acceptable loss, an amount based on your account balance rather than using indicators to analyze where to set thee stop orders for the currency pair in question.

Professional money managers advice that you shouldn't lose more than 2 % of your account equity on any one single trade position. If you've got $50,000 dollars in capital, then that would mean the max loss that you should preset for any one trade transaction is $1,000.

If you bought 1 standard lot of a currency pair, then you'd limit your risk to no more than $1,000 dollars. In that case you'd set your stop loss order at 100 pips (points) and would have $49,000 in your account left if you exited the position at the maximum loss allowed. The topic of risk management is wide and it's covered in the equity management topics.

Factors to Consider When Setting Stop Loss Orders

Most important question is how close or how far this stop loss order should be from the price where you opened the FX trade position. Where you set the stop loss order will depend on several factors:

Since there aren't any rules cast and set in a stone as to where you as a trader should set these stop loss order levels on a chart, we follow general guidelines that are used to help put these stop loss order levels correctly.

Some of the general guidelines used to set stop loss orders are:

1. Risk - How much is one willing to lose on a single trade transaction. The general rule is that a forex trader should never lose more than 2 percent of the total account capital on any one trade transaction.

2. Volatility - this refers to the daily price range movement of a currency pair. If a currency pair regularly moves up and down in the range of 100 pips or more over the course of the trading day, then you can't place and set a tight stop loss order, because if you do, you'll be taken out of the trade transaction position by normal market price volatility.

3. Risk to Reward ratio - this is the estimate of potential risk:reward. If the market factors and conditions are favorable then it's possible to comfortably give your open trade more room. However, if the market is too range bound it then becomes risky to open a trade without a tight stop loss - then do not make the FX trade at all. The risk : reward ratio is not in your favor & even setting tight stop losses will not guarantee profitable results. It'd be more wiser to search for a better trade position and setup to trade next time.

4. Position size - if the tradingposition size traded and transacted is too big then even the minimum decimal point move will be fairly large in percent terms. This means that you have to set a tight stop loss which may be taken out more easily. In most cases it is better to adjust to a smaller trade position size so as to give your trade position more room for fluctuation, thereby setting a reasonable stop loss level for this stop loss order while at same time reducing the risk of your stop loss order being taken out quickly by price volatility.

5. Trade Account Equity - If your account is under-capitalized then you'll not be able to place/set your stoploss order levels accordingly, because you'll have a large amount of money in a single position which will force you to set very tight stop losses. If this is case, you should think seriously about whether you've 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 direction is range bound & has no clear trend direction then you should use/set a tight stop or not open any trade transactions at all.

7. Time Frame - the larger the time-frame you use, the larger the stop loss level should be. If you were a scalping your stops would be tighter than if you were a day trader or a swing trader. This is because if you're using longer time frame and you figure out the price will be move upwards it doesn't make sense to put a very tight stop loss because if the currency swings a little your open position stop loss order level will be hit.

The method of setting a stoploss order that you choose will greatly depend on what type of trader you're. Most oftenly used method to identify where to set stop loss orders is - resistance and support zones. These regions give good points for putting these stop loss orders as they are the most reliable because these levels provides areas where price is not likely to move past or beyond these points, because the support & resistance levels will not be hit many times many traders use these levels to set stop loss orders just above resistance levels or set stop loss orders just below the support levels.

The technique of how to set these stop losses that you as a trader choose should also follow the guidelines explained above, even if not all of these that apply to your strategy.

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What's a Stop Loss? and Factors to Consider When Setting Stop Loss Orders

Factors to Consider When Setting Stop Loss Orders