STOP LOSS ORDERS
A stop-loss order is set up to automatically close a trading position within the trader's risk profile. A stop-loss order is a defensive mechanism that can be initiated to protect an order against deeper losses, including margin closeouts.
UNDERSTANDING STOP LOSS ORDERS
A stop-loss automatically closes an open position when the exchange rate moves downward to the level specified in the order, much like a take-profit order closes a trade when a predetermined profit has been attained. It is important to understand that stop-loss orders can only restrict losses — they cannot prevent losses in fast moving markets.
Trades are closed at the current market rate. In a fast moving market, there may be a gap between this rate and the rate set in the stop-loss. If the stop-loss is triggered when trading resumes, the trade would be executed at the current market rate, which may be lower than the stop-loss rate set in the order - this would then result in additional losses. For this reason, some traders close trades or lower leverage before trading stops for the weekend.
In the order entry example 10,000 units EUR/USD are being sold at 1.06089. With the stop loss set at 1.07079, the trade could loose 99.00 USD before automatically closing.
EXPLORING TRAILING STOP ORDERS
The key feature of a trailing stop is that it automatically follows a trade as long as the market price moves in a favourable direction, but automatically closes the trade if the market price suddenly moves in an unfavorable direction by a specified distance.
In this example 70,000 JPY are being purchased with AUD at 82.411 and the stop loss order is set at 100 pips. A trailing stop order allows a trade to gain in value, for example if you hold a long position the trigger price will keep moving up as long as the market price moves up, but it will stay unchanged if the market price moves down. Or, if you hold a short position the trigger price will keep moving down if the market price moves down, but it will stay unchanged if the market price moves up.
SETTING STOP LOSS LEVELS
An optimal point to set a stop-loss would be where it is protected but with minimal probability of untimely execution. A general rule of thumb could be to set it at the point where the trade premise would be invalidated. In other words, the point at which the trader’s reading of market direction would be proved incorrect.
For example, a long position in an uptrend may have a stop placed below the most recent swing-low since movement below this level would invalidate the premise of a sequence of higher-highs and higher-lows. Stop-losses may also be set at key price-points based on support/resistance, pivot-points or Fibonacci levels.
Once set, it is best practice not to move stop-loss orders away from the trade direction. However, if a position moves in your favour and the subsequent price action indicates a new logical level consistent with the trade premise, you may consider moving the order to the new level.
STOP LOSS ORDER PLACEMENT BASED ON FIBONACCI RETRACEMENTS
Some traders use Fibonacci Retracement levels as guidelines to place stop loss limits. Setting orders in this manner assumes considerable risk, however, if the support or resistance levels identified are fundamentally sound then the exchange rate is likely to reverse before hitting either boundary. Nevertheless, if the support or existence level is breached, setting the stop losses as described here will prevent further losses.
When prices are trending upwards and you hold a long position, one consideration is to place the stop loss just below the latest swing low rate. Since a swing low rate sometimes becomes a level of support, a falling price may recover before actually falling through a previous support level. A the stop loss is only triggered if the exchange rate falls below an established support level.
When trading in a downtrend on a short position, the approach is to set a stop loss just above the swing high since this could represent a potential resistance level. Remember, the price rate may retrace back to the swing high, but it is less likely to exceed it. Setting the stop loss above the resistance level means the order will only be triggered if the resistance level is broken.
DEFAULT STOP LOSS ORDERS
Some traders prefer not to enter stop-loss orders to instead execute them manually. This requires constant monitoring besides immense self-discipline, and is best suited for advanced traders able to closely follow their positions. Best-practice generally calls for the use of automated stop loss orders when the trade is setup.
Trading is an activity governed by probabilities. While one can and should stack the probabilities in their favour by adopting an appropriate trading strategy, there are no guarantees that the market will behave as predicted. Thus, even the most reliable strategy when executed flawlessly, may result in negative outcomes.
Gaps occur. A gap can be caused by many factors and can occur in the direction of the current market direction, or against it. If a trade is open and there is a price gap against the trade’s direction, the stop-loss would be triggered at the next available price point. In such a situation there may be a difference between the point at which a stop-loss order was set, and the price at which it actually was executed. This difference is commonly referred to as slippage and is an unavoidable risk of trading.
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