A stop-loss order is a trade management order used to manage your trades by defining and limiting risk. It instructs your broker to close out the trade once the market moves against you by a specified amount.
If you trade forex on spot trading platforms, you can set stop losses at specific price points at which the trade would be closed out on your behalf. This helps you create an exit plan that your broker would activate once your trade order moves to a price point that would invalidate it.
Here's an example. If you buy the Australian dollar/Japanese yen currency pair at a price of 87.20 and place a stop-loss order at 87.00, your stop-loss order will execute when the price reaches 87.00, thereby preventing further losses. If the price never drops as low as 87.00, your stop-loss order won't execute.
Why should you use stop-loss orders?
1 To manage your risk
Stop loss is the most helpful tool for managing your risk while trading. Once you have decided what percentage of your account you wish to risk, calculate your lot size based on the price point to be used as your stop loss.
You can also use these orders to put a limit on potential losses from the trade.
For example, a forex trader might enter an order to buy EUR/USD at 1.1500, with a stop-loss order placed at 1.1485. This limits your risk on the trade to 15 pips. Now that you know how many pips you're risking, you can calculate your lot size accordingly.
If you use 1 standard lot with a 15 pip stop loss, you will lose $150 if the trade goes against you.
If you use a 0.2 standard lot with a 15 pip stop loss, you will lose $30 if the trade goes against you.
2 Stop loss protects your account
Protecting your account ensures that in times of high volatility, your capital won't be lost in volatile spikes. Stop losses help to preserve your capital and avoid irreparable losses even when you're not watching your trades.
Where do you place a stop-loss order when buying?
Establish a trading plan by defining how you will enter trades, how you will control risk, and how you will exit profitable trades.
If you're buying a currency pair, you would be required to place the stop-loss order below the current market price. The exact price point depends on your trading style and strategy.
Many traders (especially trend traders) prefer to place these orders below a swing low. This is a good option since the higher lows of an uptrend are less likely to get violated.
A stop-loss order should not be placed at a random price level. The ideal placement allows for some fluctuation but gets you out of your position if the price turns against you.
Where do you place a stop-loss order when selling?
If you're selling a currency pair, you would be required to place the stop-loss order above the current market price. The exact placement depends on your trading style or strategy. If you're trading strategies like support and resistance, then your invalidation point would be below or above the key levels you're considering. You can decide to place stop losses at these invalidation points.
If you're trading with a trend trading strategy, your points of invalidation would be swing highs or lower highs that are formed in line with the trend.
Swing traders who have larger targets and hold trades for longer are likely to use stop losses with higher amounts of pips. You want to give the market some wiggle room for fluctuation while still protecting yourself from loss.
What is trailing stop loss?
As the name suggests, a trailing stop order moves as the price moves in favour of the trade. A regular stop loss stays in place and only gets activated when the market trades against you. This essentially allows traders to automatically lock in more gains while keeping the relative stop level in place.
While trading the forex market, make sure you use stop-loss orders to manage your trades and limit your risk exposure.
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