Understanding and Applying Stop Losses in FX Trading
One of the trickiest concepts in forex trading is the management of stop orders. As the name indicates, a stop-loss order is an order that closes out your trading position when your losses on that trade reach a loss amount you set when you initiate the stop loss order.
Setting the Stop Loss Order
There is no clear rule of thumb when it comes to placing stops, but there are some generally recognized approaches.
If your trading strategy is a forex day trading style, you might set a stop just outside the daily price range of the currency pair you are trading. This way, if the market suddenly breaks the trend that prompted you to initiate the trade and then moves far enough in the losing direction, your account is protected because your position is closed automatically by the stop-loss order.
If your trading style is more of a swing trading style, you might set your stop loss further into loss territory -- perhaps two to three times greater than the average daily trading range.
Remember, the point of the stop loss is to end the trade when the market goes far enough in the opposite direction that a return to profitability seems unlikely. Faced with a loss, you may find it difficult to face the fact that you made the wrong decision. Setting the stop when you enter the trade can help you to draw that line in the sand that protects you from an even greater loss.
If the trade starts going against you, do not give the trade more “room to breathe,” by moving to stop further away from your entry. Ir rarely pays off. If you move your stop to avoid taking the loss, you are defeating its protective purpose.
More Stop Loss Strategies
Harvesting Stops and Multiple Stops
Among forex traders, there is a belief—rarely matching reality—that if you set a stop, your market maker may manipulate the market in order to "harvest" your stop and claim the profit from your loss. In order to protect against this, some traders put in multiple stops—some closer to the current trade price than others, so there is no single currency value that will harvest your entire trade. Realistically, however, few traders—probably almost no individual traders—make trades large enough to make such a move worthwhile even if your market maker had no qualms about engaging in the practice.
Keep in mind that this is a business with a $4 trillion daily trading volume.
For other reasons, however, it can be a good idea to set multiple stops. A sudden but limited move away from your trade position may take out your first stop or even your second, but if the market then reverses, some portion of your trade will still be active.
Stop and Reverse
The stop and reverse stop loss strategy includes a stop at a certain loss point and simultaneously enters a new trade with a stop in the opposite direction. Using this strategy requires more market savvy than beginning traders can be expected to possess. Also, not all brokers accept this particular trade as a single order. In those cases, once the first stop is executed, you will need to execute a new order (one that is "the reverse" of the original order) and enter the new stop in this new direction.
This strategy addresses the trading maxim, 'Let your profits run, and cut your losses short.' One way of achieving this—or at the least a good way of making this more achievable os the trailing stop. As the name suggests, a trailing stop trails behind the market price by a fixed amount. If your trade is moving into profit, the trailing stop moves upward with the rising market price. In this way, the percentage of loss you are willing to tolerate remains about the same as the market moves in your favor.
If the market eventually moves against you, the trailing stop, having moved upward as you profited, protects you from a market move that wipes out the profit.