All profit opportunities in global markets carry a certain amount of risk, and the Forex market is no different in this regard.
While there are many ways to keep risks under control and limit risks, one of the most effective and most widely used are stop-loss orders. Stop-losses play an integral part in any well-round risk management and should be well understood, even before you place your first trade in your trading career.
Underestimating risks and accumulating losses are arguably the number one mistake that new traders make in the markets. Here, we’re going to explain how to keep an eye on your risks and limit losses when everything turns against you using a simple tool – stop-loss orders.
What is a Stop-loss and Why Should You Care?
There is a saying in the trading community that 90% of traders lose 90% of their trading capital within 90 days. While successful trading depends on a variety of factors, this statistic could have been much better if new traders used stop-loss orders in an effective way, as part of a well-designed trading plan.
So what is a stop-loss exactly? A stop-loss is a pending order that automatically exits a trade when the market turns against the position, that is, it sells a long position or buys back a short position. In essence, a stop-loss order becomes a market order once the market reaches a pre-specified price-level, also called the stop-loss level.
This helps traders to avoid unexpected losses in the event of increased volatility or during times when the trader is not in front of his trading platform. Additionally, a stop-loss order combined with a take-profit order can eliminate any further work regarding a trade by simply letting the position to perform.
How do Stop-Loss Orders Work?
In essence, stop-loss orders are buy stop and sell stop orders that get executed when the market reaches a pre-specified level. If you’re long, stop-losses sell your position, and vice-versa.
It’s important to note that a stop-loss order always follows the ask rate when applied to a short position, and the bid rate when applied to a long position. For example, if you’re long EUR/USD at 1.1050/52 and place a stop-loss order at 1.1020, the stop-loss will get triggered only if the bid rate reaches that level.
During times of high market volatility, such as when important market reports get released, imbalances in the market may lead to slippage and the widening of spreads, which in turn might fill your stop-loss order at a significantly different price. In fact, almost 44% of all stop and stop entry orders received negative slippage, according to the slippage statistics of a large broker.
Preferably, a stop-loss order should be placed tighter than the potential profit target in order to maximize a trade’s risk-to-reward ratio and improve profitability in the long run. By taking R/R ratios into consideration, even a mediocre win rate of 50% can return significant profits as the average profits of a winning position will be higher than the average losses of losing positions.
Types of Stop-Loss Orders: Pros and Cons
Depending on the technique traders use to find potential stop-loss levels for a trade, stop-loss orders can be divided into four main types: chart stops, volatility stops, time stops, and percentage stops. Another popular type of stop-losses that has seen the day of light just recently is the guaranteed stop, which will be discussed further below.
Chart stops are arguably the most effective and popular stop-loss type. They’re based on important technical levels, such as support and resistance level, trendline, channels, moving averages, or chart patterns, to name a few. The stop is then placed just below/above that level with the expectation that if it gets broken, the current momentum has shifted and the trade idea has been invalidated.
In general, a chart stop should be placed by looking at what the chart is showing us to be important technical levels and not by how much a trader can afford to lose. Therefore, a stop-loss order should be placed around an area where you’re not interested to stay in the trade if breached, allowing for an easy and fast exit out of the market.
Keep in mind that in times of high market volatility, wider stop-losses should be used to account for sudden price fluctuations. Giving a trade space to breathe avoids that you get stopped out by market noise – If you’re a shorter-term trader, placing a stop-loss with a 20 pips leeway provides you with enough room to withstand sudden price-spikes and regular fluctuations.
As their name suggests, volatility stops are based on the current or historical market volatility of the currency pair you want to trade. For example, if the average daily volatility of the GBP/USD pair is 110 pips, a trader would place his stop-loss simply 110 pips away from the entry price.
Popular indicators used in combination with volatility stops include the ATR (Average True Range) indicator. When using the ATR to identify the average volatility, traders can place a stop at 1.5x or 2.0x the ATR reading, for instance.
Time stops are stop-loss levels that are based on time. They’re especially popular among day traders who don’t want to hold their trades after the closing bells ring in London or New York, for example.
If a trader wants to close the trade by the end of the trading day, that’s also a time stop. If a swing trader wants to close his open positions by the end of the trading week on Friday, that’s a time stop as well. Time stops are very popular in Forex trading and are usually combined with other types of stop-losses.
A percentage stop is simply a stop-loss that is based on the percentage of a trading account. Unlike chart stops, percentage stops don’t follow important technical levels but are simply placed at a level that, if hit, limits losses to the pre-specified trading account percentage.
Bear in mind that percentage stops have no relation to the common trading practice of position sizing. Instead of using percentage stops, traders are usually much better off by using chart stops and sizing their position to risk only a small percentage of their trading funds. Your position size should be calculated based on the distance of your stop-loss, and not the other way around!
Last but not least, guaranteed stops are stops that guarantee to exit a position once the market reaches the pre-specified price-level. Remember our discussion about slippage and the widening of spreads? Guaranteed stops eliminate those risks completely by ignoring underlying market conditions.
Since your broker takes the liquidity and slippage risks of guaranteed stops, this type of stops usually comes at a small fee called the GSLO (guaranteed stop-loss order) premium. The fee is calculated by multiplying the GSLO premium (indicated on your broker’s website) by your position size. Also, bear in mind that not all brokers offer guaranteed stops.
Static vs. Dynamic Stop: Which are Better?
Besides the four main types of stop-losses discussed above, stops can also be grouped into static and dynamic stops.
A static stop is quite simply – static. Once placed, they remain at their level until the stop gets triggered or you close your position manually.
Bear in mind that any type of stop-losses can be static or dynamic, depending on your trading style and strategy. A chart stop can be either left at its initial price-level or moved to adapt to changing market conditions (e.g. to a new support or resistance level.) Similarly, a volatility stop can be placed at the average weekly volatility of a currency pair or moved each day when used the daily volatility.
When placing a static stop, the potential gain has to be considered. The risk-to-reward should be at least 1:1 or higher to take the most advantage of your average win rate over the long run. According to a research conducted by a large Forex broker, traders who use a reward-to-risk ratio of at least 1:1 (i.e. they’re risking $1 to make $1) are on average 3 times more likely to turn a profit than traders who didn’t adhere to this rule!
Dynamic Stops – Chasing the Flux
A dynamic stop-loss order is based on an indicator such as a moving average or a volatility indicator in order to remove any guesswork from the decision and determine a point after which the trade idea becomes invalidated. As its name suggests, a dynamic stop is not static. It moves with the current market conditions and the underlying indicator to whom it has been attached.
Popular indicator setups for dynamic stops include simple and exponential moving averages, such as the 100-period of 200-period EMAs. The 200-day EMA is especially important since a large number of traders are following that indicator and make their trading decisions based on it. The 200-day EMA (or any other longer-term MA) are also often used as a dynamic support or resistance level, so watch out in times when the market approaches one of those MAs.
The Art of Trailing Stops
Trailing stops are a special type of dynamic stop-loss orders that move your stop-loss automatically with each new price-tick that goes in your favour. They allow you to stay inside a trade as long as possible and to squeeze out as much profit as the market potentially allows.
While trailing stops automatically move your stop-loss with each new price-tick, they don’t pay attention to technical levels or fresh support and resistance levels along the way. That’s why some traders might find it useful to move their stops manually. Depending on your trading strategy, you could move your stop and lock in profits by placing your stop at a new swing high or swing low, for example.
Trailing the Stop Manually
As the position starts moving towards the profit target, profits can slowly be locked in by manually trailing your stop. This is usually done by moving the stop loss below the next minor area of support or resistance, depending on whether a long or short position is taken, respectively.
While trailing a stop manually slowly reduces the risk for a trader, it can also result in the stop being hit prematurely if the approach is done too aggressively. Therefore, this strategy is best used when the trader is certain that a move below the set stop-loss level, such as below a previous swing high in a long position, would mean that the trade’s profit potential is clearly undermined.
Additionally, this strategy can be used to let profits run until the stop is finally hit and can lead to a very good profit if the momentum of the market persists for longer than previously anticipated.
A popular approach to manually trail stops is to move the stop-loss to break-even once the profit reaches one-third of the profit target. As the profit continues to rise towards and above two-thirds of the profit target, move the stop-loss to the one-third level, and so on. This way, you’re locking in profits as the trade is performing and avoid losses if the market suddenly reverses.
Just like with other approaches, keep in mind to provide the trade with enough breathing room to avoid getting stopped out on unimportant price-fluctuations.
Automatic Trailing Stops
Alternatively, most brokers offer trailing stops that automatically move the stop-loss with each up-tick of a winning position. Let’s say you place a trailing stop of 50 pips in EUR/USD. As the position is going in your favour, the trailing stop will automatically move the stop-loss to lock in profits and limit losses along the way. A one pip-move in your favour moves the stop-loss one pip in the direction of the trade.
Trailing stops are especially popular in trend-following strategies as they keep trailing the stop as long as the trend persists. Try placing a trailing stop with a size equal to the average correction size of the trend to avoid getting stopped out during market corrections.
Stop-Losses and Risk-per-Trade: A Famous Duo
When talking about stop-losses, we can’t ignore the concept of risk-per-trade. Risk-per-trade refers to the total risk you’re taking on any single trade, in percentage terms of your trading account. For example, a risk-per-trade of 1% means that you’re risking 1% of your trading funds on that trade.
A well-defined risk management strategy needs to take into account the risk-per-trade you’re going to take when trading. Taking too much risk, i.e. risking a large chunk of your trading account on a single trade can quickly add up losses and wipe out your trading account. This is one of the most common mistakes of beginners in the market.
Imagine trading on a high risk-per-trade of, let’s say, 10%. A string of losses of 5 consecutive trades, which is not that unusual, would wipe out 50% of your trading account. To return to your initial trading account size, you would need a return of 100%! That’s when emotional trading kicks in and you start to make irrational trading decisions, overtrade, and blow your entire account. This can be easily avoided by sticking to a healthy risk-per-trade of up to 2%, as encouraged by many respectable trading sources.
The size of your stop-loss order directly influences the maximum position size you can take on a trade – the tighter the stop, the larger position can be taken and vice-versa. Position sizing has many touching points with the concept of risk-per-trade and chart stops.
Here’s an example of how to calculate your position the smart way by simultaneously using a chart stop and respecting a pre-defined risk-per-trade.
Let’s say you want to go long on EUR/USD at 1.1050 with a stop-loss just below the recent support of 1.1010. This is a chart stop – a stop based on important technical levels. Your trading account has a size of $10.000, and your risk management guidelines allow you to take a risk-per-trade of up to 2%.
How would you calculate your position size? Here we go, in a few simple steps:
Step 1: Calculate your risk-per-trade in dollar terms. Your total loss shouldn’t exceed $200 ($10.000 x 0.02)
Step 2: Determine your stop-loss size. In our example, the chart stop has a size of 40 pips.
Step 3: Calculate your desired pip-value to stay inside your risk-per-trade. $200 / 40 pips = $5 per pip. That’s the maximum pip-value you’re allowed to take.
Step 4: Determine the position size that returns a pip-value of $5. Since one standard lot of EUR/USD has a pip-value of $10, the total position size you’re allowed to take is 0.50 lots or 50.000 units of euro.
To summarize, here’re few key takeaways on stop-loss trading:
- Pay attention to the R/R ratio: A stop-loss should be smaller than the potential profit of a trade to take advantage of the theory of big numbers. Over a given sample of trades, you’ll be able to grow your account even with a 50% win rate.
- Use chart stops: Stop-losses should always be placed by looking at what the chart is indicating as an important technical level. Once a major support or resistance level breaks, you don’t want to stay in the trade anymore. Chart stops usually return better results than other stop-loss types.
- Guaranteed stops: If you don’t want slippage and market conditions to impact the execution of your stop-loss order, consider using guaranteed stops that will always trigger your stop at the pre-specified level – guaranteed.
- Invalidation area: This refers to the idea of chart stops. Place your stop in an area where the trade idea gets invalidated if the area breaks.
- Account for market volatility: In order to avoid getting stopped out by regular market noise, always add some leeway to your stops. For instance, if you’ve identified an important support at the 1.1050 level and want to enter long, add 20 pips of leeway and place your stop at 1.1030.
- Use trailing stops in trending markets: To stay inside a trend as long as possible, use an automatic trailing stop with a size equal to the average price-correction (counter-trend move) of the active trend.
- Follow the 2% rule: Don’t risk more than 2% of your trading capital on any single trade. As your account grows, consider reducing your risk-per-trade to 1%. This allows you to stay in the game for longer, even in the case of a string of losing trades.
- Tighter stops offer higher profit opportunities: The tighter the stop, the more leverage you can use and the higher the possible profit.
- Position sizing: Always calculate your position size based on the distance of your stop-loss level, not the other way around.