Do You Really Need A Stop Loss?

Do you really need a stop loss? The quick answer is: “yes.” The long form of the answer is “yes, if you choose not to blow up your Forex trading account.” There are a multitude of reasons for using a stop loss, but there are some strategies that can be deployed to forgo a stop loss, although it is typically the realm of institutional traders to do things like that.

The stop loss is your biggest friend

The stop loss is your biggest friend, as volatility in the currency markets can pick up at any moment. There can be a surprise announcement, some event halfway across the world, or worse yet something going on while you are asleep. You simply cannot predict everything that’s going to happen, so the stop loss is your guardian angel. Looking at the Forex markets, there are a multitude of reasons you could see a sudden spike in price.

For example, in the last couple of years we have seen the Swiss National Bank defend the 1.20 level in the EUR/CHF pair, refusing to allow the pair to drop below that level as the Swiss franc had gotten far too expensive. However, on January 15, 2005, the SNB suddenly abandoned the peg, and allow the market to drop as they had been protecting that level for a couple of years and it had finally gotten too expensive. Large amounts of institutional money was coming in and buying the pair every time it got close to the 1.20 level, because it was “easy money.” However, as soon as the Swiss stepped away from the currency markets, the pair collapsed and fell several candles in milliseconds. Around the world, there were stories of retail traders who had refused the common sense of putting in a stop loss and were wiped out.

Imagine being an American trader. You had a position in the EUR/USD pair relying on the Swiss National Bank to protect you. Suddenly, as you awake on January 15, you find out that your account is empty. Your broker is demanding you deposit more margin, and for some people it was even worse than that: they actually owed their brokers money because orders could get filled fast enough.

Granted, this is a very extreme situation, but it’s not uncommon for a pair like the GBP/JPY pair to fall 120 pips while you are sleeping. Some people use stop loss is as a “disaster stop”, but it’s designed to protect you when your analysis isn’t correct, and let’s be honest - incorrect analysis is simply part of the game.

Stop losses are there for a reason

Not only are stop losses there to protect your account against disaster, but it also represents a “line in the sand” as to where your analysis is proven incorrect. If it is proven to be incorrect, you simply exit the market and realize that you live to fight another day. Unfortunately, far too many of you will be moving stop losses in order to avoid taking loss, but the successful trader is willing to cut losses rather quickly. Ultimately, the successful trader understands that if your analysis is proven incorrect, it’s better to keep your losses very small. However, if your analysis is proven to be the correct analysis, moving your stop loss is in your favor to lock in gains is a perfectly acceptable strategy. This is allowing the marketplace to tell you when it’s time to get out after a large run higher.

Some other strategies

Forex Trading Stop LossInstitutional traders quite often use options to protect against currency fluctuations, but that becomes very complicated at times. Most retail traders are going to be better served simply accepting a loss as soon as it appears and going on with their lives.

For example, if your stop loss is 1% of your account, it’s not a huge disaster. However, if you don’t use a stop loss and you simply use a strategy of hope, you could find that you are down so much that you are never going to be able to recover that money.

In order to use the options of strategy, quite often if a trader is long in the EUR/USD pair, they will buy a put simultaneously, with the idea of at least recovering some of the losses if the trade goes against them in the spot Forex market. Otherwise, if the trade does work out, the option expires worthless. However, there are plenty of other factors in the options that makes it a much more difficult and time-consuming to figure out how to protect yourself on a tick by tick basis.

Depending on where you live, you may be able to head your trade with the same broker by taking a trade in the opposite direction. However, typically this is a scenario where you limit the amount of profit that you can have, because one of those trades will absolutely be a loss. This is different than having a stop loss in the trade that works out for you, because in theory at least, the profit potential is unlimited.

You should never trade without a stop loss

You should never trade without a stop loss, under any circumstance. There are too many reasons why you could lose a lot of money. Granted, some of the points that I have been making in this article are a bit extreme, but at the end of the day you never know when something’s going to happen. Beyond that, it’s a way of forcing your account to neutral again if the trade doesn’t work out. You can also use it as a way to take profit if the market pulls back after a big move in your favor.

The Forex world is littered with the bodies of people who thought they were smarter than the market and couldn’t be bothered to take a loss. There is no such thing as a “100% successful strategy”, other than limiting your losses and expanding on your gains. Losses come regardless, so protecting yourself is the only thing you can do.

Christopher Lewis has been trading Forex for several years. He writes about Forex for many online publications, including his own site, aptly named The Trader Guy.