Setting a stop-loss (SL) is a crucial aspect of trading. Especially in the forex market, where wild swings in prices are an every day occurence, traders not using stop-losses potentially place their entire accounts at risk. Furthermore, the aspect of trading in which stop-losses fall under, known as risk management is a crticial component of a successful trading strategy. To help minimize losses it is highly suggested that traders decide how much risk they will take before entering the market.
WHERE TO SET A STOP-LOSS?
Those new to trading might ask where to set a stop-loss. Although it’s tempting to simply to pick a fixed amount of pips one is willing to risk and set the stop at that level, this is not recommended. The main reason is that price movements tend to follow patterns, and setting a stop blindly could risk a premature stop out, causing unncessary losses. It is recommended, therefore that a stop-loss is set at a significant support or resistance level. Traders can also use indicators, for example, moving averages or Fibonacci retracements, to supplement their decision making process.
HOW TO MANAGE RISK USING STOP-LOSS ORDER?
When setting a stop-loss it’s also important to determine how much capital to risk. The majority of those trading for a living or for institutions tend to risk no more than 1% of their capital on a single trade. This is not a set rule as many probably risk more from time to time, however, risking 5% or more of the capital on a single trade can be problematic. If 10 trades end up losing in a row, which is not all uncommon, a trader risking 5% on each trade will be down 50%. Naturally, it will be very difficult to bring an account balance with a 50% loss of capital back to break even. There are two suggestions for avoiding this scenario:
To have a well capitalized account;
1. To risk less on each trade.
2. An account that experienced 10 losses in a row but risked only 1% on each trade would only suffer a 10% drawdown, something quite normal in the volatile forex market.
WHAT YOU SHOULDN’T DO WITH STOP-LOSS?
Finally, it’s worth mentioning that a margin call should not be used as a stop-loss. Traders approaching the market with this method will notice wild swings in their accounts, and while it is quite possible to quickly double the balance, it will only take a few margin calls before those gains are lost. One can compare a margin call to a fire extingshuier in a building, only to be used for extraordinary scenarios.