Trading can be a rewarding but risky endeavor. While the potential for high returns is alluring, the risk of significant losses is always lurking in the background. One of the most effective ways to manage this risk is by using stop-loss orders. In this blog post, we'll delve into the various types of stop-losses, how they work, and how you can use them to protect your trades.
- Stop-loss orders help manage risk by setting a predetermined exit price, with trailing stop-losses offering dynamic adjustments.
- While useful, they have drawbacks like slippage and potential for premature sale.
- Effective exit strategies consider asset volatility, liquidity, and personal risk tolerance.
What is a Stop-Loss Order?
A stop-loss order is a tool that allows traders to set a predetermined price at which a trade will be closed automatically. This type of order is designed to limit a trader’s potential losses. For example, if you buy EURUSD at 1.0695, you can set an exit at 200 pips (1.0495). If the pair drops that level or below, it will trigger, and the trade will be closed asap (but not necessarily at that exact price).
Stop-Loss vs. Trailing Stop-Loss
In a fixed stop-loss order, the price you set remains constant. This type of order is useful for traders who want to set a specific price level that, if reached, will trigger the closing of the trade. This is a straightforward way to protect your position from significant losses.
Trailing Stop-Loss Order
This is a more dynamic and advanced way to manage risk. It adjusts itself as the asset price changes, always maintaining a certain distance (either in percentage or pips) from the pair’s highest price. For example, if you used a 3:1 risk-reward ratio and set a 200 pips trailing stop on EURUSD at 1.0695, it would trigger if the pair fell to 1.0495 or lower. If the EURUSD rises to 1.1295 (you go get them, tiger!), the exit will automatically adjust to 1.1095, safeguarding your profit.
Advantages and Disadvantages of Using Stop-Loss
One of the most significant benefits is the ability to manage risk proactively. By setting a predetermined exit point for your trades, you can limit potential losses, which is especially useful in volatile market conditions.
Trading often involves emotional highs and lows, which can lead to impulsive decisions. Stop-loss orders take emotions out of the equation, allowing you to stick to your strategy even when market conditions are stressful.
Especially with trailing exits, you have the flexibility to lock in profits while still giving a bullish (or bearish) pair room to rise (or fall). As the pair value changes, the stop adjusts, potentially allowing for greater profits.
In a highly volatile market, a pair’s price can gap down below your stop-loss level, leading to an execution at a much lower price than expected. This phenomenon is known as “slippage,” and it can result in larger losses than you had planned for.
No Guarantee of Execution
There’s a risk that your order may not execute at all, especially if the asset price gaps past your limit price. This can leave you exposed to further losses.
Potential for Premature Sale
A temporary dip in price could close your trade automatically before the pair rebounds. This could result in missing out on future gains.
How to Set Stop-Loss Levels
We have a whole article on how to avoid mistakes on this, but let’s go through the basics. Knowing when to close a trade is crucial to your success. Here are some factors to consider:
The more volatile an instrument is, the wider you may want to set your closing price to avoid being stopped out by normal market fluctuations. You can use indicators like Average True Range (ATR) to gauge a pair’s volatility.
For pairs with low liquidity (i.e. exotic pairs), setting a fixed exit can be risky because the lack of buyers could mean that your sell order is executed at a much lower price than anticipated. Always check the pair’s trading volume before placing a stop-loss order.
Your personal risk tolerance should also play a role in your exit strategies. If you’re risk-averse, you might set a tighter boundaries, closer to your entry price. On the other hand, if you’re willing to tolerate some drawdown in hopes of higher returns, you might set your limits further away.
One popular method for setting stop-loss levels is the percentage method. Here, you decide what percentage of the pair price you’re willing to risk before closing the trade. For example, a common percentage in forex day-trading is 1%. In fact, it is not uncommon to use a 3:1 risk-reward ratio, which means that you take profit when the pair gains 3% and close when it drops 1%.
Exit Strategies and Manual Selling
Why You Need an Exit Strategy
The short answer is: because you do, it’s the sensible thing to do. It helps you define your goals and outlines the conditions under which you’ll close a trade, either to lock in profits or limit losses. An exit strategy can help you avoid emotional decision-making, which is often detrimental to your investment performance.
Manually Selling Your Position
If you want to sell your position immediately, you can place a market order. This type of order guarantees immediate execution but offers no control over the price at which your position will be sold. This is useful when you need to exit a position quickly but can be risky in volatile markets.
If you prefer to have control over the selling price, you can use a limit order. This type of order specifies the minimum price you’re willing to accept to exit your trade. While it guarantees that you won’t close below a certain price, it doesn’t guarantee that the order will be executed, especially in fast-moving markets.
You can set your limit orders to expire at the end of the trading day or keep them open until they are either executed or canceled. This type of order is known as a Good-Til-Canceled (GTC) order and can be useful for traders who have a specific price target in mind and are willing to wait. Depending on the rules of your prop trading firm, you might want to watch out for rollover fees and the ability to keep positions open over the weekend.
Stop-loss orders are an invaluable tool for any trader looking to manage risk effectively. By understanding the different types of exits and how to use them, you can make more informed decisions and protect your funded account from significant losses. Always remember, investing is not just about making profits; it’s also (and many people would say chiefly) about preserving capital and managing risk.