What is a stop loss?

This is my stop loss definition. A stop loss is probably the most important tool to learn how to use and something which will turn out to be your best friend in your trading world.

I have said in previous posts that you should never ever enter a trade without knowing exactly how much you are going to lose in a worst case scenario. The way we do that is by using a stop loss order.

When you place a trade you have already decided which way you believe the market is going to move, up or down based on your trading method and thought process. For this example we will say that we believe the market will go up.

Although I haven’t covered this yet we will have a target in mind for the amount of market movement which will produce the amount of profit we have planned for this particular trade. Lets say 20 points or pips as they are more commonly known.

We have placed a trade, what happens next?

We have clicked the trade button and we are live in the market. Just because we believe that the market price will rise, it does not mean that it will happen straight away or even happen as we believe at all. To guard against the market moving in the opposite direction to the way we would like we use a stop loss tool. For this example, to try to keep this as simple as I can I will use a scale of 0-100 instead of an authentic market price.

The market price when we entered the trade was 50. We are looking for a 20 point/pip trade profit so would like the market price to rise to 70 or above.

Looking at the previous time period we can see that the lowest the market price has been recently is 38 a while back and it has not been lower for quite some time. To begin the trade we would look to set our stop loss just below that low point, maybe at 35.

We make that decision based on 2 things.

  1. We believe that the market is going to rise not fall.
  2. If the market does begin to fall, recent trading activity strongly suggests that it will not go lower than it has in the recent past.

That means that we could lose a maximum of 15 points/pips. If we were trading at £1 per point that would mean a maximum loss of £15.

In this simplified example, if we had read the market completely incorrectly and the market went down our trade would automatically be closed out by our trading platform when the market hit 35 and met our stop loss.

This trade would result in a £15 loss. We knew that was the worst case at the start of the trade and we were happy to take that amount of risk.

What is a trailing stop loss? How does it work?

If however we have read the market correctly and the market price begins to rise then we have an option to reduce our potential loss by using another tool called a trailing stop loss.

As the name would suggest this is a moving version of a stop loss and follows, or trails the market price. These trailing stop losses can be either automatic or manual. I always prefer to use a manual trailing stop loss which I alter myself.

In our example the market price was at 50 when we entered the trade and it has now risen to 60. As the market has risen by 10 points/pips we can move our trailing stop loss to mirror this rise. We move it up 10 points/pips from 35 to 45. We now stand to lose only 5 points/pips if the market goes against us, the difference between the staring point of the trade of 50 and our current stop loss of 45. Our maximum loss is now reduced to £5 instead of £15.

Look to reach break even point as soon as possible.

In an ideal world every trade that we enter will be successful and net us the intended profit target. We do not however live in an ideal world.

The best that we can do as a Forex trader is to attempt to reduce our potential losses to a minimum as soon as possible. A trailing stop loss allows us to do this when the market is moving in our favour.

In our example here as soon as the market price hits 65 we could move our trailing stop loss to 50 and ensure that at worst we break even if the market suddenly reverses on us. If or when the market reaches 70 we could happily close our trade out and take our 20 points/pips profit and either stop trading for the day or begin looking for our next potential trade.

There is clearly a temptation to move the trailing stop loss too quickly to get to the break even point as soon as the market starts to go in our favour. The risk with that is that the markets do not move only in one direction at a time. The price action ebbs and flows and those who believe that the market will rise fight against those who believe the opposite will occur.

If we have moved our stop loss too early then one of these ebb and flow movements may end our trade early. True we have not lost as much as we could have but we will also have cut down our chance of a fully successful trade too,

As a result of this we always keep a healthy gap between the current trading price and our stop loss. This allows the market room to move up and down and as long as it moves more in our direction we are fine.

 

Mistakes to avoid if you wish to be a trader long term.

If you have done your research, used the information given to you by your preferred trading analysis method and stayed focused and disciplined many of your trades could work out in the way I have just described.

If that is the case why do so many people lose money with Forex trading?

Lack of discipline, greed and letting in emotion are the main culprits here.

Lack of discipline.

Discipline is an essential tool in your Forex trading toolbox. Without it you are lost and destined to fail and fail pretty quickly.

Assuming that you have followed your plan, used your preferred analysis method and entered a trade with your stop loss in position then you should be OK. If however you lose that discipline and alter something about your trade once it is open, change the profit target, second guess the market or move a stop loss in an incorrect way then you risk ruining the trade which you so carefully set up in the first place.

Greed.

This is a killer. You think you are onto a winner, you think you are a better trader than you actually are. You trade with a bigger % of your trading bank than you planned to because this trade is the one. The price goes in your direction and hits your target price. You want more, you take that risk and can see the £ signs hitting your trading account. You are so confident that you do not move your stop loss. Suddenly the market reverses against your forecast. 10 minutes ago you could have been out of your trade with your profit target safely banked but now you have lost it all.

To compound this result you now decide to move your stop loss further away. You knew you were right and this is just a blip, the price will go back up again soon. We call moving your top loss like this giving the market room.

You may be right of course but you may also be wrong and moving your stop loss has just caused you to take an even bigger loss than you planned.

Don’t ever let greed take over your trading. Set a plan and a profit target and stick to it.

Emotion.

The market does not have feelings, It is a mechanical machine which responds to traders betting on which way the market will move and sheer weight of money. Nothing more.

It does not know exactly where you have placed your stop loss or what your profit target is and it doesn’t care.

Trust me, the market will go against you at times, far more often than you would like. That is why we incorporate stop losses as our most important tool, to limit the damage done to our trading bank.

I know only to well that the price will move just enough to take out your stop loss and close your trade before shooting off in the direction you wanted it to and soaring past your intended profit target.

These are the trades you remember only to well. You seem to forget the ones which struggled then suddenly went your way and made a nice little profit.

Never take anything that happens in the market personally. Keep emotion out of it. It will only affect your decision making in the future.

Summing it all up.

I accept that this has been a very simplistic view of how a trade works. I just wanted to give you a simple example of what happens. There are far more parts involved in a trade but that does not have to make it any more complicated or difficult.

I hope that I have pointed out a few of the reasons why you should not be afraid to start trading Forex and also described some of the pitfalls of not doing it properly.

Please feel free to comment or ask further questions on the subject of stop losses.

Filed under: Tools and Strategies

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