One of the most important things to do before trading with real money is to learn how to use stops (or stop-losses as they are also known).
WHAT IS A STOP LOSS?
A stop loss is an order to trade at a price level that is less favourable than the current 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. To give an example, let’s say the EURUSD is trading at 1.3660 and you leave an order to ‘sell on stop’ at a price of 1.3589. In this case your order wouldn’t be triggered unless the EURUSD fell to 1.3589.
So why would you leave an order like this if you could go straight into the market and sell at a higher level? Well, the most common reason is that you want to protect an existing “buy” position. If you were betting on the EURUSD going up and had a “buy” bet at 1.3670, it would be sensible to limit your loss should the EURUSD move against you. Let us say that you had undertaken your money and risk management and worked out that there was a danger of the currency pair falling further if it broke below 1.3600. If so, you could opt to place your stop just below here (let’s say 1.3589) to protect your risk capital should the EURUSD fall further. If your stop is triggered then you would ‘sell’ at 1.3589, closing your position for a loss of 71 pips. Of course, the currency pair could bounce from here which would be frustrating. But if it 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.
HOW CAN A STOP BE USED?
Stop orders are used to limit an investor's exposure in the market. Using stops correctly is a vital component of successful risk management and this is crucial when dealing with leveraged products.
A STOP CAN BE USED IN TWO DIFFERENT (YET RELATED) WAYS:
a) A simple stop order can help reduce losses on a spread bet if the underlying market moves against you.
b) Stops can also be used to lock in profits.
HOW DO YOU WORK OUT WHERE TO PLACE YOUR STOP LOSS?
First of all you must have a firm idea about how much of your trading capital you’re prepared to risk on any one trade. This is a subject which is covered in other guides where money management is considered in more detail. However, the crux of this is to divide up your trading 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 technical analysis and 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.
Here’s a chart which shows an area of price resistance (the dark red horizontal line). 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 (indicated by the light red horizontal line). This will offer some protection should resistance fail to hold and prices break out to the upside.
It’s important to avoid leaving stops right on lines of support and resistance, as well as on significant round numbers such as 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.
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.
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