Setting a stop loss is critical when trading Forex (or any other market, in my opinion). This is because the same reasons that make the Forex market so profitable can make it disastrous. Specifically, when trading Forex you’re often dealing with leverage and extreme volatility which, if you’re not careful can cause serious financial pain.
Think of this example: the Swiss National Bank decided to abandon its peg of €1.20 that it has been enforcing for a couple of years. Many retail traders were wiped out because they had not placed the proper orders, or worse yet simply over levered their position. The 1.20 level had been so extraordinarily reliable in the EUR/CHF market as support, that when the SNB decided to stop trying to lift the pair there, people all over the planet were wiped out. Beyond that, there were Forex brokers that were in trouble as well.
Beyond that, there are plenty of other events that aren’t nearly as drastic but happen more frequently. You can simply get up and walk away from your computer for five minutes to turn around and find that some headline has crossed the wires to move your currency pair 300 pips. In that situation, you had better hope that it moved in your favor! However, Murphy’s Law dictates that it never will.
After reading this, I hope that the simple stop order will become your new best friend. Simply put, a stop order is an order that becomes executable once a set price has been reached and then is filled at the current market price. The broker is commanded to close out your position, regardless of how quick the market is moving. While this could result in slippage (a situation in which you didn’t get the exact price you asked for), most of the time your order will get filled properly. Otherwise, if the market is moving too quickly against you, it will continue to exit the position until you’re completely flat. Most of the time, a stop order is referred to as a “stop loss” order, meaning that it protects your account if the position goes against you.
In the above example with the SNB leaving the currency market, you would have suffered some slippage. However, the market fell something like 500 pips in just a few moments, and for those who were not protected many of them ended up hundreds of thousands of dollars in the hole. This is what is meant when a broker tells you that “you can lose more than your initial investment.” The last thing you need to do is be on the hook to your broker for some drastic amount of money. This can be easily avoided by taking this precaution. Beyond that, it helps enforce discipline as once it gets head you know that the trade did not work out in your favor. It’s a crucial part of money management, and something that is ignored due to the most perilous of trading enemies: the trader’s ego.
Limit orders are a different animal. A limit order is one that is set at a particular price. It’s only executable at times when the trade can be executed at that specific price. For example, if you put a limit order to buy a currency at 1.1753, it will only buy that currency at that exact price, or at a lower price if you get the opportunity to do so. This assures that you won’t pay any more than your desired price. This is a way to enter the marketplace with precision, while at the same time serving as a great way to save money on trade. This is a situation that continues to evolve into more complex trades, such as the stop-limit order.
In this scenario, you are looking at the same thing as a limit order, in the sense that you may wish to buy the currency at 1.1290, but you also put a limit price of 1.1300 as well. If the price of the currency moves above the 1.1290 stop price, the order is then activated and turns into a limit order. As long as this order can be filled under the 1.1300 level, the trade will be filled. In other words, it protects you from gaps or poor slippage. Granted, not all Forex brokerages offer this order type, but it may be something you want to look for when choosing a new broker.
Never trade without them
Forex markets are very risky if you’re not properly protected. Using the stop loss and limit orders mentioned above can help protect your assets. Unfortunately, some people cannot accept losses, so therefore they choose to forgo these orders. Some professional traders will use options as a form of stop loss, but that is a much more complex strategy. At this point, you should only be thinking about when the trade has proven your thesis incorrect. For example, if you are looking to buy the GBP/USD pair and think that as long as you stay above the 1.2750 level, things are okay, then your stop loss needs to be at that level. This gets you out of the market and away from the computer screen. Your stop loss will protect you if you are not there to watch the situation or cannot act quickly enough to a change in attitude.
Beyond that, these orders can get you out of the market with a profit as well. It’s not all about safety, because sometimes the market will move when you’re sleeping and hit your take profit target. Once they do, your account will be credited with that financial gain, all while you are sleeping or out living your life.
One last thing that I would point out is that you should never move your orders unless you are moving them in reaction to a gain. In other words, there can be an argument made for moving your stop loss closer to price action, but never further way. This is because once a trade is wrong, it is wrong. However, if you wish to lock in some profit, that is a completely different scenario.