Understanding and Applying Stop Losses in FX Trading

Business graph analysis on FX Trading

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One of the trickiest concepts in forex trading is the management of stop-loss orders, which effectively close out your trading positions when losses hit predetermined levels. Stop losses are most effective at halting trades when severe markets dips make returns to profitability unlikely. And although some investors may find it psychologically difficult to acknowledge wrong decisions, swallowing your pride can go a long way towards stemming losses.

While there aren't any rigid rules when it comes to placing stop orders, there are some generally-accepted guidelines. For example, forex day traders might set up stops just outside the daily price range of the currency pairs traded. This way, if the market direction that initially prompted the trade suddenly reverses, the stop loss protects the position. In another example, those who favor a swing trading style, might set stop losses further into loss territory--perhaps two to three times greater than the average daily trading range. 

More Stop Loss Strategies

Harvesting Stops and Multiple Stops

Among some forex traders, there is a false belief that if you set a stop-loss, market-makers will manipulate the market in order to "harvest" your stop and claim profits from it. To protect against this, some traders put in multiple stops—some closer to the current trade price than others, so there's no single currency value that will harvest your entire trade. But realistically, few traders make large enough trades to justify this practice. But there are other reasons to set up multiple stops. Namely: if a sudden move away from your trade position takes out your first stop--or even your second, if the market then reverses, at least some portion of your trade will still remain in play.

Stop and Reverse

The stop and reverse stop loss strategy includes a stop at a certain loss point, but simultaneously enters a new trade--with a stop in the opposite direction. This strategy requires more market expertise than most beginning traders possess. Also, not all brokers accept this particular trade structure as a single order. In those cases, once the first stop is executed, you'll need to execute a new order that reverses the original order, by entering the new stop in this new direction.

Trailing Stops

This old trading adage: "Let your profits run; cut your losses short" is achievable with the "trailing stop". As the name suggests, these trades trail behind market prices by fixed amounts. If your trade is tilting towards profit, the trailing stop moves upward with the rising market price. This way, the percentage of loss you're willing to tolerate remains the same, as markets swing in your favor. If the market eventually moves against you, the trailing stop--having risen as your profit, protects the obliteration of those recent gains.