When learning how to trade Forex, you will come across many different order types such as market buy/sell orders and various types of limit orders. Market orders are placed manually, whereas limit orders get executed automatically when price reaches a predetermined price point. Stop Loss is a highly important limit order and it is recommended every trade to be followed by placing one.
Stop loss definition
A Stop Loss order is a type of order that allows traders to set a predetermined price at which an active trade will be closed if price goes against predicted direction. Stop Loss orders can be modified, but it is recommended modifications to be a part of your trading strategy and not an impulsive activity.
Why is it important for traders to understand stop loss?
- Understanding Stop Loss in trading can help traders keep their trading balance safe from blowing up.
- Stop Loss orders help traders determine their risks and calculate risk to reward ratios.
- Stop Loss orders help traders to limit their losses and lock in profits.
Stop Loss explained in more detail
Stop Loss orders are placed with or after a trader sells or buys an instrument. It is recommended every trade to be followed by a Stop Loss order, as it prevents further losses if trade goes against prediction. It’s important to note that the order will not be activated until the price reaches the SL target.
The biggest mistake novice traders make is to trade without a Stop Loss. Some traders even change the order and increase their risks while hoping the trade will reverse. What happens if the price gets close to the new Stop? Traders can take larger losses or move Stop Loss again and risk losing half of their trading account.
When you have an active position, your psychology changes, which is why it’s important to plan a trade and trade the plan. Stop Loss placement and choosing a proper size for your orders is essential in risk management. In general, traders avoid risking more than 1-5% of their trading capital per trade.
Determining Stop Loss target prior to opening a trade will help you calculate your risks and potential rewards. If SL target is too great, it means that the trade is not worth the risk.
Stop loss example in trading
Now, let’s take a look at the Stop Loss example in EUR/USD trade. In the following example price tested a significant level around 1.0000. Finally the price was able to breach the support, fell significantly, and started trending. The prior support became a resistance. Which is a great sell signal. In addition, the round number played its part as a physiological level. If we had sold the EUR/USD pair once the support became the resistance, the Stop Loss target would be right above the resistance line and above the round number. It’s easy to see that the potential Profit Take target is much greater that the Stop Loss target and therefore, the trade was worth taking.
Main takeaways from stop loss in trading
- Stop Loss orders are used to limit losses and/or lock in profits.
- Stop Loss orders help calculate risk to reward ratios.
- It is recommended for each trade to have a proper Stop Loss. If a Stop Loss target is too large, trade is not worth opening.
- Stop Loss orders are an essential part of risk management in trading.
FAQs on the stop loss order
How do stop loss orders work?
Stop Loss orders are placed with or after placing an active trade. Stop Loss orders get triggered if price goes against prediction. SL orders can be modified once placed, however, it is not recommended to change the order impulsively. The biggest reason why novice traders blow up their accounts is that they let their losses run and cut their profits short.
What is a good stop loss price?
Stop Loss order should always be placed based on market conditions and not based on a trader’s balance. In general, position traders never risk more than 1-5% of their trading account per trade. For high frequency traders that place multiple orders, risks per trade are even lower. Ultimately, how much your Stop Loss should be depends on a trading strategy that you’re using.