Stop Loss Orders

Introduction

Usually within a few minutes or at most, a couple of hours, new FOREX traders will discover the concept of the stop loss order.

The purpose of this order is to establish the trader’s maximum acceptable loss on a currency exchange transaction.

A prudent, well disciplined trader will usually calculate this maximum loss level either before submitting an entry order, or very shortly thereafter. Monetary losses are theoretically limited only by the trader’s total account equity without this safety measure in place.

Basic Types of Stop Loss Orders

Stop losses can be set according to a maximum acceptable dollar risk amount, a percentage of total trading equity or average price range, and time duration of the trade.

Monetary Stop Loss

The trader sets a fixed dollar amount he/she is willing to risk on a trade. Before entering an entry order, the trader examines charts and the related indicators to ascertain if the market price activity will result in the stop loss being located where it will allow enough room for the trade to develop. If prices are moving quickly and the market volatility suggests a high probability of the stop loss being triggered quickly, the entry order is never submitted. The trader then undertakes further market analysis to determine whether to increase the dollar amount of the stop loss or wait for price movement to decrease.

Percentage Stop Losses

A percentage of total account equity that is designated by the trainer as an acceptable risk level defines this type of stop. One conservative recommendation is to limit total losses in a traiding session to no more than 20% of trading capital and no more than 2% on any one FOREX transaction. This is equivalent to $200/thousand account equity per session and $20/thousand per transaction. As with the monetary stop, the trader first determines if the price activity permits the stop to fall within these parameters. Trading 1000 units of most of the major currency pairs would make each pip of price change equivalent to 10 cents, so it should be evident that the 2% per transaction stop loss allows for 200 pips of drawdown before the stop loss will be triggered. This level is more than adequate for shorter time frame trades and provides the trader with the opportunity to evaluate trading skills.

When employed as a percentage of average price range, the percentage stop takes the highest price of the selected time frame compared to the lowest price for that same time frame and produces an average price. Currency markets will frequently spend the majority of the time within the highest and lowest price of the selected time frame. This range can be calculated manually, but most trading platforms can do it automatically with the use of a moving average indicator.

Time Duration Stop Loss

This is a scenario where the stop loss order is not submitted simultaneously with the entry order.

It takes considerably more experience and trader discipline to use a timed stop.

The trader first determines how long he/she will permit a transaction to last.

The general rule of thumb is that the trade should be exited within a time period no longer than three times greater than the selected trading time frame.

This means that trades undertaken in a one minute time frame should be exited within three minutes. Trades executed on a one hour time frame last a maximum of three hours.

If the trader is willing to accept the risk, trades can be given more time, especially in a quiet market. Just remain aware that the longer you spend in a market that is moving against you or just moving sideways, the higher the probability that matters will only get worse, sometimes drastically so.

Benefits of Stop Loss Orders

The greatest benefit to using stop loss orders is that the trader knows in advance what the maximum loss of a transaction will be. This knowledge is a fantastic psychological comfort. It minimizes some of the fear that is associated with taking a risk on an uncertain outcome. FOREX trading offers plentiful unknowns without adding this one to the mix.

This sensation of psychological security permits the trader to remain objective and focused on the present, even offering the opportunity to exit a losing trade <i>before</i>the stop loss is triggered, further preserving capital for future trades.

A very practical benefit to using a stop loss is that it frees the trader from the need to constantly monitor a trade to guard against a catastrophic loss.

Many experienced trainers will honestly admit that leaving their screen for a while, to stretch or otherwise decompress, has provided them with some of their best trades. Not being chained to a computer monitor preserves mental and physical energy, facilitating objective trading decisions.

Stop Loss Warning

You must have absolute trust in your broker to use stop losses. Some less than ethical market maker brokers engage in a practice known as stop harvesting.

A market maker broker takes the opposite side of your trade. They can manipulate the price data stream to trigger your stop, adding your loss to the their win column as well as capturing the spread cost they charged you for the trade.

This is simple enough to prevent. At the minimum, have at least one other data stream with which to compare your broker’s. If your stop losses are getting triggered by your broker’s price data and the other data stream is clearly not displaying those prices, your broker is stop harvesting. Find a new broker, pronto.

Conclusion

Several types of stop loss orders and reasons for using them have been discussed. There is one final type of stop loss order to be considered.

The Trailing Stop

This may be your hands down favorite any time you are so fortunate as to be able to use it.

A trailing stop, rather than protect the trading account from losses, guarantees some amount of profit. When a trade is positive to an adequate degree, the initial stop loss that was established to cap a potential loss is trailed behind the market. It is first is moved to the breakeven point, guaranteeing a trade without any loss, then it is moved incrementally in the direction of the market to lock-in profits.

Any time spent in this trading mode will be the most pleasurable that you’ll ever experience as a FOREX trader.

For more information on stop loss orders or to begin forex trading contact www.lucrorfx.com today!

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