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What is a Stop Loss?

A stop loss (or stop) is an order to trade at a price level that is less favourable to you than the current available dealing price. A “sell” stop is an order to sell below the current market price while a “buy” stop is an order to buy above the current market price. The question is why would anyone want to do that? The answer is that such orders are a vital part of risk management when dealing in FX.

Margin trading on FX with Spread Co

FX, like spread betting and trading CFDs, is done on margin. This means you only have to put up a small percentage of the value of the underlying asset to control a large amount of it. As a result, your potential profits are magnified, but so are your losses. This is why it is vitally important to understand fully the risks involved with trading FX. With Spread Co you don’t actually buy or sell the underlying asset. Instead, you take a view on whether the price offered by Spread Co on the underlying currency pair will rise or fall. Fortunately, at Spread Co you can use stops and even guaranteed stops to help you control your risk.

An example of a stop-loss

Let’s say the EURUSD is trading at 1.1260 and you leave an order to ‘sell on stop’ at a price of 1.1189. In this case your order wouldn’t be triggered unless the EURUSD fell to 1.1189.

So why would you leave an order like this if you could go straight into the market and sell at a higher level? The most common reason is that you want to protect an existing long position. That is, you’ve already bought the EURUSD in the expectation that the euro is set to strengthen against the US dollar. So let’s say you bought the EURUSD at 1.1270 as your charts told you that the pair had a good chance of rallying up to 1.1500 or so. However, your technical analysis also suggested that there was a danger of the currency pair falling sharply if it broke below 1.1200. Consequently, considering your money management and how much of your risk capital you were prepared to expend on this trade, you opt to place your stop just below here (let’s say 1.1189) to protect yourself should the EURUSD fall further. If your stop is triggered then you would ‘sell’ at 1.1189, closing your position for a loss of 71 pips. This would mean that if the FX pair continued to fall your stop-loss would have ensured that your position was already closed which could end up saving you a lot of money.

The fact is that anything can happen after you have opened a trade.  You may have predicted events perfectly in which case your profit target is hit without the market ever moving against you. But this is very unusual, even for the most experienced traders. More often than not, prices will move against you at some stage. Sometimes this may just be a minor short-term move, but at other times it may mean that you’ve got the market direction wrong. So the aim is to work out the best place to put your stop to give you the best opportunity to make money while taking the smallest amount of acceptable risk. What you want to avoid is:

a)      Choking the trade with a tight stop-loss which may be triggered by typical intra-day volatility before the market moves as you predicted.

b)      Moving your stop-loss further away from your opening level to prevent it from being triggered. More often than not this will result in larger and more debilitating trading losses. 

c)      Taking on too much risk for a relatively small potential profit

Where to place your stop

So how do you work out where to place your stop-loss? This involves a combination of money and risk management. First of all, you must decide how much of your trading capital you are prepared to risk on any one trade. Prudent money management should ensure that you only ever risk a small percentage of your total trading capital on any one position. This means dividing up your funds into a number of smaller packages to ensure you never risk too much on a single trade.

The next thing to consider is risk management which is where stops come in. Risk management involves some form of technical analysis, even if it is just to establish possible areas of support and resistance. This means studying charts. Prices are constantly moving, and often they create patterns which become visible when plotted on a chart. These patterns help traders to decide the best places to buy and sell. Of course, it’s important to appreciate that charts can only show us where prices have been previously. They can’t predict the future. Nevertheless, studying charts helps traders to identify whether a market is trading in a range or trending in a particular direction. As prices fluctuate, it’s often the case that support develops when prices repeatedly bounce off a certain area. Resistance builds when prices repeatedly pull back from a particular area. By attempting to buy near support and sell near resistance a trader can increase the likelihood of a successful bet. And by placing sell-stops below a support area and buy-stops above resistance, traders can protect themselves if prices break out from the range or trend.

As an example, here’s a chart which shows an area of price resistance (the blue horizontal line with the arrows pointing downwards). The idea is to sell close to but below this line in the hope that prices will fall from here. At the same time, the stop loss should be placed at some point above here. This will offer some protection should resistance fail to hold and prices break out to the upside. 

You should then calculate what your loss would be if the market moves against you and hits your stop. This is your potential loss which should never be more than the risk capital for that trade as worked out with your money management. If it is, then try reducing your bet size. If the potential loss still exceeds your risk capital, then wait for a better entry level, or abandon the trade altogether and wait for a more suitable opportunity.

One other tip: it’s important to avoid leaving stops right on lines of support and resistance, as well as on significant round numbers such as 10, 100, 250 or 5,000. There can often be a concentration of orders at key levels which can trigger a flurry of trading activity. Sometimes this is the precursor to a significant move and a change in market sentiment. But other times it can just be an overreaction which quickly reverses. This could result in prices being pushed through your stop, but only temporarily. So give yourself a bit of leeway just in case. This is why we chose a stop at 1.1189 in the above example rather than leaving the stop at 1.1200

As you gain in experience, you’ll find plenty of useful drawing tools which will help you identify key areas of support and resistance whether a market is range bound or trending. These include Bollinger Bands, Fibonacci Retracements and Andrews’ Pitchfork. Not only will these tools help you identify entry levels for your trades, but they can also help you set stops and profit targets as well. Planning your trades in advance with stop losses and limits helps to take the emotion out of trading. And that can help you become consistent and profitable over the long term. 

 

Posted by David Morrison

Tagged: Trading Guides

Category: Trading Guides


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