How to Use a Stop Loss in Forex Trading

What is a Stop Loss (SL)?

The Stop Loss is an instruction mandating the broker to automatically close an active trade position if the price of the asset moves against the trader’s position by a certain number of pips.

The Stop Loss is a feature built into a trading platform to prevent uncontrolled losses from occurring, given the fact that such events may be in process when the trader is away from the trading station.

How does a stop loss work?

Usually what happens is that if a trader is in one direction and the trade moves contrary to the trader’s expectation, the broker will begin to shop for someone who can buy off the position from the trader at the price set as the stop loss.

So if the trader was short on the currency pair, the logical action would be for the broker to look for a trader who wants to go long at the stop loss price. When this occurs, the long order is executed for the second trader, which is basically an order to buy off the short position from the first trader at the stop loss price.

The reverse is the case if the first trader was long on the currency pair. In conditions where the broker is the market maker, then the broker will be the trading entity that buys off, or sells off the position, depending on the side of the track the initial trader is on.

Entering a Stop Loss Order at GekkoMarkets

Entering a Stop Loss Order at GekkoMarkets

Why should traders use a stop loss?

a)    Loss Protection

This is the traditional role of a stop loss. It is used to prevent uncontrolled losses. However, it must be said that the stop loss works best in conditions where there is no slippage or undue market volatility. If heavy market volatility occurs, then a stop loss would not work as it would be very hard to find another trading entity to take the position when prices are collapsing. This scenario can also happen after weekend gaps.

b)    Profit Protection

Stop-loss orders are not only used to prevent losses. They can be used to lock in profits. In this capacity, the stop loss is actually the “trailing stop”. Next time you have an open profitable position, apply the trailing stop and see what happens. This action simply moves the stop loss to a few pips behind the market price in profit territory. The price of the stop loss in this case will adjust itself as the market price fluctuates.

c)     Calculating Risk-Reward Ratios

The stop loss is an integral part of setting up a trade plan. In other words, the trader can use the knowledge of the stop loss (risk to the trade) to set the Take Profit (reward), and use this to determine how many losses are needed to offset gains for a breakeven point to be reached. This introduces trade discipline.

How to Set a Stop Loss (SL) Correctly

When setting a stop loss to prevent uncontrolled losses, remember that it should be set against a price level which will protect it from being triggered. This happens in the context of support and resistance. A good stop loss should therefore be set just below a support level (for a long trade) or just above the resistance level (for a short trade). This way, prices that are dropping or rising towards a stop loss have a good chance of being rejected at those key levels, thus saving the trade.

What would constitute support and resistance for the purpose of setting stop losses?

a)    Pivot points

b)    Trend lines

c)     Moving averages

d)    Channels

e)    Swing highs and lows

The following charts demonstrate how to set stop losses using these parameters.

a)    Pivot points

Here we can see the stop loss set below the S1 support area. In this case, the S1 is shown as the support area, and the stop loss is set below it. In this role, the stop loss is used for loss protection.

stop loss 1

b)    Trend lines

With a trend line, you can always set a stop loss as shown below:

stop loss 2

For this short trade example, we see that the stop loss can be set above the trend line, with the trader aiming to go short when the price action is rejected at a downward sloping trendline (depicting a bearish bias).

c)     Channel

It is very easy to use channels as benchmarks for setting stop loss areas, as the boundaries of the channels serve to demarcate the trade entry areas, above or below which a stop loss can be set depending on if the trader is going short or long.

stop loss 3

This is an example of a long trade setup. The green circle marks the trade entry point and the brown line shows the area where the stop should be applied.

d)    Swing highs/lows

In this chart we see a stop loss set for a long trade, using the swing lows as the benchmark. A swing low is determined by a repeat of price being rejected at a price low, when historically there has been a price rejection at the same area.

stop loss 4

There are traders who will obviously argue against the use of stop loss orders. These are usually scalpers who typically pick a few pips at a time. However, what would happen if the price were to suddenly reverse on a trader big time? That would be like the rope harnesses of a climber ascending Mount Everest suddenly snapping without a backup. Without a stop loss the consequences would be catastrophic. Always use a stop loss.

Adam

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Adam is an experienced financial trader who writes about Forex trading, binary options, technical analysis and more.

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