We have mentioned stop-losses many times in this course so far, and for good reason, we need them! Time to dive a little deeper into the specifics.
As you know, the forex market can be volatile and difficult to predict at times. Even the best traders get it wrong and find that the market moves in the exact opposite direction to what they predicted.
Even if all our indicators are pointing in one direction it is still entirely possible that the market can move violently in the other. A major economic event, a new banking policy, and even strong rumours can affect the price out of nowhere, we must be prepared for this.
A lot of newbie traders will make the mistake of riding the trade it and hoping (praying) that the market will turn back in their favour. Others will cut their loss immediately as soon as they see it turn red and unfortunately, both of these strategies are incorrect.
What we need is a stop-loss. Simply put, a stop loss is an order that we place into the market that automatically executes when the price hits a certain level. It removes all the stress and anxiety from trading without a stop loss and acting the market run away with our entire trading balance at risk.
Sometimes it’s best to cut your losses and live to fight another day.
Where to place our stop loss
As we touched upon earlier, we can calculate precisely how many pips we are willing to lose for each trade.
If we know that we only want to risk 1% of our account, we should calculate how many pips that equate to, and then we know the maximum point at which we can place our stop loss. However, this is NOT the best strategy. We should always set our stop-loss at the point of invalidation.
This means that we should place our stop loss at the point where the reasons why we entered our trade are no longer valid.
For example, let’s say that we expect the price to bounce off a support and reverse into an uptrend. Rather than setting our stop loss at 100 pips below the support, we could set it at maybe 10-15 pips below the support.
That way, we know that our initial trade theory has been proven to be wrong (the support did not hold), and we can exit for a small 10-15 pip loss.
For the sake of this trade, it would be unnecessary to lose all 100 of our allocated pips based on our risk management strategy.
This is the MAXIMUM you are willing to lose on a trade, not how much you should lose each time.
Other than a setting a regular set stop-loss we can also utilize what is called a trailing stop loss.
A trailing stop loss will move based on fluctuations that occur during the trade.
For example, if you set a BUY order on EUR/USD at 1.1000 with a 50 pip trailing stop at and the market moved up to 1.1050 then the trailing stop would move up to 1.1000.
Every-time the trade moves in your favour the trailing stop loss will trail behind by 50 pips. This is a great way to lock in profits and attempt to ride successful trades out for as long as possible.
The stop loss will only trigger once the market has moved against you by 50 pips.
Moving your stop-loss to your entry position
One thing that traders like to do is to move their stop loss to the point of entry when a trade goes in the favour. This can be a great tactic as it essentially removes all risk from the trade and it effectively a “free shot” at making extra profits.
While this can often be a good idea and can real help remove the stress from a trade it can also mean that you turn some winning trades into break even ones
Sometimes the market can fluctuate violently and it can take out your stop loss before carrying back on its trajectory.
If this happens you can see your trade closing before you get to your profit taking zone and you have just missed out on a winning trade.
While it’s okay to do this sometimes, it’s almost always better to set your stop loss at the point of invalidation.