Stop Loss in Forex
Stop loss order is used, when you want to close a certain position at a certain price. In other words, stop loss is used to prevent further loss. This tools comes in handy when you are not actively monitoring your trades. In this article we will tell you how to use stop loss in the most efficient way.
Why is using stop loss important in forex?
Stop loss is an order, given to the broker through the trading platform, to close a certain position at a certain price. This will prevent further loss, in case a position is moving against your expectation. Stop loss orders can be used either in long or short positions.
Stop loss removes emotions from trading in forex. This will prove useful specially when the trader isn’t able to constantly monitor open positions. Stop loss is important in forex for several reasons, but the most crucial one is that no one is able to predict what is going to happen in forex, no matter how powerful the financial settings are or how powerful a trend is.
Future prices are unknown and each entry is a risk. Forex traders may be successful in more than half of their trades, but still lose money due to weak financial management. Weak financial management will cause traders to loose money more than anything else. To prevent such event, traders shall know how to use a stop loss order.
How to place stop loss order?
Forex traders can specify a certain static price for stop loss level. The stop loss order is executed to prevent further loss according to the risk/reward ratio determined by the trader. Each time a position is opened, the stop loss option is shown in the New Order window in MetaTrader platform. The specified stop loss at the beginning of each trade can be modified or even removed later.
Traders usually specify the stop loss level at the beginning of each trade. For example, a trader may buy EUR/USD pair at 1.1500 and place his/her stop loss at 1.1485. This will limit the trader’s loss to 15 pips. Therefore stop loss is a crucial tool in financial management.
When a position moves to the positive zone, trader moves the stop loss level so that some of the gained profit is saved in case the market reverses. If a trader buys EUR/USD pair at 1.1500, and the price rises to 1.1600, the trader may move his/her stop loss to 1.1540, to save at least half of the profit.
Some times traders use Trailing Stop. Trailing stop automatically moves when the position moves in your favor. You can easily set Trailing Stop in MetaTrader platform. You just need to enter the number of pips you want your stop loss to be away from the current price, when the market is moving in your favor. In the previous example, if the trader sets a Trailing Stop with 50 pips, when the market reaches 1.1600, the stop loss automatically moves up to 1.1550. If the market reaches 1.1620, the stop loss will move up to 1.1570.
Calculating the position of stop loss
There are two ways to calculate the position of stop loss: pips under risk and the amount of investment exposed to risk.
The amount of investment exposed to risk, is more feasible, since it actually shows the amount of money you may loose. This amount could be calculated in U.S Dollars. For example, if you risk 5 pips on EUR/USD pair and the volume of your trade is 5 micro lots, the risked amount is calculated as follows:
pips under risk * pip value * trade volume (lot)
6 * 1$ * 5 = 30$
Pips under risk is actually used to calculate the amount of investment exposed to risk. For example, if you enter the market at “Y” and place your stop loss at “X”, the pips under risk will be:
pips under risk = Y-X
If you buy EUR/USD at 1.569 and place your stop loss at 1.575, you are risking 6 pips per lot. This will come in handy when calculating the amount of investment you have exposed to potential loss.
Control your risk
The amount of investment you expose to risk, should be only a portion of your trading account. Generally, this amount should be below 2% , or in a more suitable case, below 1% of your capital.
For example, if a trader trades 5 micro lots EUR/USD, and places his/her stop loss 6 pips away from the entry price, the actual risked amount will be equal to 30$. To obey the 1% rule, the trader shall have 100*30=3000$ capital to minimize the risk.
This way you could rapidly calculate how much capital you need for each certain position. If you have 5000$, you are allowed to risk 50$ in each trade. If you have 30000$, you can risk up to 300$ in each trade. You can even risk less than 1% of your capital in each trade, depending on your risk management and trading strategy.
Always use stop loss according to your trading strategy. Risk management rules vary with trading strategies. Stop loss will only prevent further loss if the position moves against your expectation. You should know how much you have risked in every position you have opened, this way you can monitor your trades efficiently and make the most profit out of them. Always try to risk less than 2% of your capital in each trade, to prevent your capital from shrinking even in critical situations.
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Written by: Mohsen Mohseni (Aron Groups).