Table of Content
Table of Content
Stop Loss- What Is It? How To Use It In Your Trading? | A Beginners Guide
The importance of using a stop loss can not be understated, no matter what kind of trader you are. Stop losses create security by limiting your exposure to risk and preventing potential steep declines in the value of your trading account. The smart way to trade is as if each move were made with percentages – there will always be wins and losses along the path, but don’t forget that Risk Management essentially means Loss Management! With a stop order placed correctly, those dips on Wall Street won’t take out all your earnings when they occur – invest wisely and protect yourself from unnecessary financial damage today!
What is a ‘Stop loss’ or ‘Stop Order’?
Scenario: Let’s say you’ve done all your analysis and you’ve spotted an opportunity to go Long(Buy) on EUR/USD. As with any trade setup, you would have an entry price which you can also pre-set manually and an exit price (take-profit). Both price levels can be entered on any broker terminal, be it Metatrader 4 or Trading View. Just to note, for ‘shorting a currency pair’ or selling a currency pair, your entry price will be higher than your exit and vice versa for long (buy).
Now, everything is looking great so far, you’ve executed your trade based on your bias and analysis. All of sudden the market drastically turns against you and starts to shift the other way. Maybe this is because of a major Fundamental announcement which does not favour the Euro against the dollar.
What do you do now? Many traders panic in this situation, especially ones who haven’t placed a stop loss or who don’t know a thing about Risk Management.
Definition- A ‘Stop loss’ is a predetermined price level: where if a trade doesn’t favour one’s bias or trading analysis, it is then cancelled by your broker incurring a specific loss. In other words, when you get it wrong (YOUR TRADE) the stop loss ensures you don’t lose beyond that specified level. For shorting or selling a currency your stop loss will be at a price higher than your entry price and for longs or buying a currency pair the stop loss will be below your entry price. The illustration below shows the red zone representing the area where trade will be in loss and the stop loss level price at 1.13868.
How to place a stop-loss order?
The image below shows a stop loss order example via Tradingview. The example is of a long trade execution quoted for EURUSD at 1.15709. Tradingview and Metatrader4 are amongst the easiest and most popular terminals for executing trades. However, there are web trader versions like the XTB’s xtrader5 which is also very popular and user-friendly. It might be useful to check if you can sync your broker account with tradingview, this will only be applicable if your broker gives permission.
As shown below, you can either enter the price of your stop loss or the desired PIP amount. If you enter a price it will automatically calculate the PIP amount you are risking, 50 pips in the case below. Once you execute a trade you can always adjust your stop loss amount as long as your trade is in play. A good practice is always to fix your stop loss because it creates discipline when it comes to long-term risk management.
Why use a stop loss to prevent losses to your trading?
As the saying goes by the famous hedge fund manager Paul Tudor Jones, “Don’t focus on making money; focus on protecting what you have.” Protecting your capital should be your number one focus; if you don’t have that mindset of preserving your capital then you’ll end up depleting your trading account. You may be asking what is the best stop-loss strategy. There isn’t a particular one but you must have an overall risk strategy which you consistently implement over the long term.
The famous one per cent rule could be a great place to start; that means you risk 1% of your capital on every trade. Let’s say you lose your first trade; your capital account will be down to 99%. This means your next trade should be 1% against 99%
A day trader may consider risking half a per cent per trade as they may have more than 10 open trading positions on any given day. Therefore, the maximum risk is 5% of their capital.
As Forex CFD trading is leverage trading (i.e. profits & losses are amplified), it all boils down to the individual trader and their risk tolerance. If you can tolerate risking/losing 3% per trade, then obviously you will stand to profit more based on risk/reward.
Brokers offer better features: Guaranteed Stop Loss
Sometimes your trades may go beyond your stop loss price by a couple of pips thus increasing your loss. Brokers refer to this as ‘slippage’ and it mostly occurs during times of high volatility. Brokers such as XTB & EasyMarkets all have the guaranteed stop loss feature that will enable you to be certain of knowing that your trade will terminate at your Stop loss price level.