The importance of using stop-loss orders in forex

Market movements can be unpredictable. Regardless of what investor sentiment and prevailing trends might suggest, a market can move in any direction at any time.

A stop-loss is one of the few mechanisms that you have to protect yourself against adverse movements. It’s a function offered by brokers/trading providers to limit losses when a market moves in a contrary direction to your position. You can implement it by setting an ’exit’ level a specified amount of pips away from your entry price.

In this lesson, we’ll outline the different forms of stop-losses, including static stops and trailing stops, as well as highlight the importance of using them in your trading.

Why is a stop-loss order important?

Stops are critical for a multitude of reasons, but it can really be narrowed down to one thing: you can’t predict the future.

Regardless of how strong the setup might be, or how much information might be pointing to the same conclusion – it’s impossible to know a market’s future direction, and each trade carries the risk of losing some or all your capital.

Forex stop-loss strategies

Below are five stop-loss strategies you can apply to your trading:

1. Setting static stops

A static stop is the simplest type of stop-loss you can implement on your trades. It involves setting a price level at which to exit a market in an effort to cap your losses.

However, because the stop becomes a market order once the set price level is reached, there’s no guarantee that your order will be executed at the price you specified, and you may only get the next best price.

For example, let’s consider a swing trader in Sydney who wants to open positions during the Asian session.

Let’s say they anticipate that volatility during the European or US sessions would affect 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’re wrong. So they set a static stop on every position they trigger. For instance, they may want to limit losses on all their positions to 50 pips.

They also want to set a profit target that’s at least as large as the stop distance, so they set every limit order to a minimum of 50 pips.

If the trader wanted to set a risk-to-reward ratio of one-to-two 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 base the static stop distance on an indicator such as average true range (ATR), which tracks a market’s volatility in a given time period. The primary benefit behind this is that you’re using actual market information to assist in setting your stop level.

So, if you set a static stop-loss order of 50 pips and a static limit order of 100 pips, what would the 50-pip stop mean in a volatile market versus in a quiet market?

If the market is quiet, 50 pips can be a large move whereas if the market is volatile, those same 50 pips can be looked at as a small move. Using an indicator like ATR, pivot points or price swings can enable you to use recent market information to analyse your risk-management options more accurately.

3. Trailing stops

A static stop-loss can greatly improve a new trader’s approach, but more advanced market participants use stops in a different way to further maximise their money management – like implementing trailing stops.

These are stops that’ll be adjusted as the market moves in your favour. The main benefit of using them is that they can further mitigate the downside risk of being incorrect in a trade.

Let’s say, for instance, that you took a long position on EUR/USD while the price was at 1.1720. You place a trailing stop 167 pips below the current level, at 1.1553.

If the market moves up to 1.1720, your trailing stop will also move up to 1.1720 from the initial stop value of 1.1553.

This moves the stop to your entry price – also known as the ‘breakeven’ point – so that if EUR/USD reverses and moves against you, you won’t be faced with a loss since the stop is set to your initial entry price, essentially removing your initial risk in the trade.

It’s important to note that some jurisdictions allow brokers to enforce the trailing stop function.

4. Manual trailing stops

If you want the utmost control of your trades, you can manually adjust your stops as the market moves.

The chart below highlights the movement of stops on a short position. As the position moves further in favour of the trade (lower), the trader subsequently moves the stop level lower. When the trend eventually reverses (and new highs are made), the position is then stopped out.

5. Fixed trailing stops

You can also set trailing stops that adjust incrementally. For example, you can set stops to adjust for every 10-pip movement in your favour.

Say you take a long position on EUR/USD when it’s priced at 1.3100 and add an initial stop at 1.3050. The market moves up to 1.3110, and so your stop adjusts to 1.3060 to maintain the 10-pip distance. After another 10-pip movement higher (to 1.3120), your stop will once again adjust another 10 pips to 1.3070.

This process will continue until such a time as the market reverses and the stop level is hit or you manually close the trade. Simply put, if the trade goes against you from that point, you’ll be stopped out of the trade at 1.3070 as opposed to the initial level you set at 1.3050, effectively adjusting your profit-potential while capping your losses.