Stop loss: what it is and why you should use it

How to use stop-loss orders

First, you should place your SL order tighter than the potential profit target to maximise the trade's risk-to-reward ratio and improve profitability in the long run.

Secondly, whatever technique you're using to find potential SL levels, remember that there are five different types of stop-loss orders: chart stops, volatility stops, time stops, percentage stops, and, lastly, guaranteed stops.

Chart stops are the most effective and popular SL type, based on critical technical levels, such as support and resistance levels, trendline, channels, MAs, patterns, etc. Generally speaking, because a chart stop is so technical, you ought to be looking at it. It would help if you placed it by looking at its essence, the chart, instead of how much you can lose.

Volatility stops are based on a currency pair's current or historical market volatility. You can use indicators in combination with volatility stops to identify average volatility, which will determine precisely the amount of pips where your SL will be placed.

Types of stop-loss orders

Let's understand what types of stop-loss orders exist.

Fixed stop-loss order

In this order type, the stop price is established at a fixed level, depending on the risk-to-reward ratio. Usually, the stop loss goes below the entry price for the buy trade and above the entry price for the sell trade.

The stop-loss order automatically triggers a close when the price reaches the stop levels. Its main purpose is to limit potential losses for investors.

1. Entry
2. Stop loss
3. Target

One benefit of a fixed stop-loss order is that it remains constant, regardless of market fluctuations. Investors often use this order to safeguard their investments and maintain a steady stop-loss level. Let's say you forecast that the price of the Japanese Yen against the U.S. dollar will go up; you buy at 150.00 and set a safety net—your stop loss—at 149.90. If the price falls to 149.90, your trade automatically closes to limit your losses. This safety net is a Fixed stop-loss order that guards your money.

Trailing stop-loss order

A Trailing stop loss changes when the market price goes up for the trader. For instance, if the price rises, the Trailing stop loss goes up, too, keeping a certain distance from the current price. This helps traders secure profits while also protecting them against losses.

Let's say a sell order for EURUSD is initiated at 1.1000 with a trailing stop-loss order set at a 15-pip interval. Should the price appreciate 1.1015, resulting in a 15-pip loss, the stop loss is triggered, automatically closing the position. Conversely, if the price depreciates to 1.0985, the Trailing stop loss adjusts to 1.1000, the original entry price. Further depreciation to 1.0970 would then move the order to 1.0985. Subsequent execution of the stop loss at this level would still yield a 15-pip profit.

1.Price
2.Asset
3.Time
4.Offset in % (selected by the investor)
5.Trailing Stop order (follows the price upwards)
6.Stop price reached—market order is executed

This dynamic stop loss mechanism allows traders to participate in downward price trends while mitigating the risk of significant losses should a price reversal occur.

Advantages and disadvantages

Using stop-loss orders offers several potential benefits for both experienced and newbie traders. The section below discusses why traders should consider adding a stop loss to their trades.

Advantages of a stop loss:

• Managing multiple trades. Traders can use stop-loss orders to manage multiple trades at once by setting different stop levels for other trades. This is essential as traders can manage multiple positions more efficiently, considering their risk appetite.
• Securing profits. The traders can use the Jump Stop Loss after the trade moves considerably into profit. This way, they can secure profit if the trade does not hit the profit target and moves against the position.
• Potential for less loss. The main benefit of stop-loss orders is that they help prevent significant losses that could harm a trader's account. By effectively managing risk and limiting losses, traders can enhance their overall performance and reach their investment objectives.
• Convenience of automatic execution. Emotions can lead to poor decision-making in trading. Stop-loss orders minimise emotional influence by automatically closing a trade when it reaches a specific price. This process helps traders avoid impulsive decisions that could adversely affect their results.

Can we call a stop loss the perfect tool? Of course not. After all, it has several disadvantages:

• The Forex market changes fast. Sometimes, the price can jump so quickly that your order might be filled at a different price than you set. This is called 'slippage'. Instead of selling at your planned price to limit your losses, you might sell at a worse price, meaning you lose more than you expected.
• While stop-loss orders are designed to limit losses, they don't guarantee you'll sell or buy at your exact price. The so-called slippage is more likely in volatile markets or when there aren't many buyers or sellers (low liquidity). This means your stop loss could be filled at a much less favourable price, leading to more significant losses than you intended.

How to determine the price level for a stop loss

Where you set your stop-loss order is your personal choice. Some people are comfortable with more risk and will lower their stop loss, meaning they're willing to lose more before selling. Others are more cautious and set it higher, accepting smaller potential profits but reducing risk.

Using a percentage is one common way to figure out where to set your stop-loss order. Before you start trading, you decide what percentage of your investment you will lose. For example, you may sell if the price drops 5% from where you bought it. This helps you decide on a specific stop-loss price.

Final thoughts

• A stop-loss order automatically closes a trade when the price reaches a pre-defined level, limiting potential losses.
• This level is set below your entry price for buy trades and above for sell trades. The trade closes if the market moves against your position.
• There are two main stop-loss order types: fixed, where the exit price remains constant, and Trailing, where the exit price adjusts as the market moves in your favour, safeguarding profits already made.
• Stop-loss orders might be associated with a safety net that helps avoid impulsive decisions during market fluctuations. However, they cannot eliminate potential risks and losses.