What does a stop loss have in common with a seatbelt and a smoke alarm? They’re all simple tools to use but can have serious implications if you don’t.
In trading terms, a stop loss acts in a similar way to a safety belt or smoke alarm, getting you out of trouble before things get too serious. Some call it a safety net, some call it protection, some call it insurance. Whatever you call it, the important thing is to make use of it because, no matter how good you are at trading, no trader can be right 100% of the time and you only need to end up on the wrong side of a trade a couple of times to appreciate why you need them.
What a stop loss does in practice is to prevent a losing trade from getting out of control. In this regard, it works in an opposite way to a take profit order.
Let’s take an example where you’ve done your homework and have come to the conclusion that the price of a particular currency pair is going to go up. You enter into a trade and set your take profit level above the current market price. The market duly follows your prediction, hits your predetermined point and your trade automatically closes, netting you a tidy profit.
Now consider the reverse situation.
Having done your homework, you’ve concluded that the price is going to go up. But there’s a seed of doubt in your mind so you also set a stop loss at a point below the current market price. Unfortunately the market doesn’t match your initial optimism, the price starts falling and you start losing money. Here’s where the stop loss shows its worth. Instead of plunging to unknown levels, your stop loss gets triggered and caps your losses. You have to understand that in this scenario, where a stop loss is triggered, your account is still going to take a hit but it will likely be far more manageable compared to letting the trade potentially run away completely.
Setting a stop loss is a particularly effective method of risk management for traders who aren’t able to monitor their trades constantly. It allows you to set your trades and limits then walk away, safe in the knowledge that if things do go against you while you’re not watching, the stop loss will protect your balance just as associated limit orders will lock in the gains.
Unfortunately there’s no hard and fast rule about where to place a stop loss and there are a few different types of stops to consider. You need to account for market volatility and not set your trigger points too narrowly, but likewise you should be realistic about how far prices will move and not shoot too wide of the mark. Technical analysis will help with setting limits, but different traders have different strategies and approaches and tolerances to risk so the ultimate decision rests with the individual.
But what every Forex trader has in common is a fundamental need to manage risk. Using a stop loss is amongst the simplest ways mitigate yours.
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