Reducing Trading Risk with Stop Losses
Stop loss orders are an essential tool to limit risk on trades. Although they are not fail-safe, they significantly mitigate trading risks.
Stop loss orders are an essential tool to limit risk on trades. Although they are not fail-safe, they significantly mitigate trading risks and they can make the difference between limiting your risk to a certain level to having your entire trading equity wiped out.
Regardless of how well your trading strategy might have evolved, it is crucial that you use stop loss orders on your positions.
What is a Stop Loss Order?
A stop loss is basically a pending order that is sent to your broker and is triggered when the asset’s price drops to the stop loss level (in the case of a long trade) or rises to the stop loss level (in case of a short trade).
For example, if you were long on EURUSD at 1.10 and you set your stop loss order at 1.09, that means that if EURUSD falls to 1.09, your stop loss order is triggered thus closing out your trade with a loss of 90 pips.
It is important to understand that stop loss orders are based on the current bid and ask price.
How to Set the Correct Stop Loss Levels
When using stop loss orders, it is important to consider the Bid and Ask prices. The bid price is the price at which you can sell and the ask price is the level at which you can buy.
If you were long on a trade and you have a stop loss order, it is triggered only when the bid price hits your stop loss level. Likewise, if you were short, your stop loss order is triggered only when the ask price hits your stop loss level.
Most traders don’t realize this fact and often complain that they were stopped out of their trade without the price hitting their stop loss. The fact is that the MT4 chart displays the bid price or the price where you can sell. The ask price is not displayed on the chart, and therefore adds to the confusion.
Stop Losses – Limit Risk or Trade Invalidation
Stop losses can be used as a way to limit risk. With this approach your focus is purely on the risk factor but it could result in your trades constantly being stopped out.
When using stop losses at the invalidation point of a trade set up, you are not only limiting the risk but are also using it to invalidate your trade idea as well. The second approach to using stop losses makes more logical sense than using stops merely to limit risks.
Stop Losses are not Fail-Safe
Contrary to the popular notion, a stop loss is not a fail-safe mechanism. If there is no buyer or seller at the stop loss level you specified, it will not get triggered.
For this reason it is highly recommended to trade only the highly liquid markets, such as the currency majors which are the most liquid instruments in the forex markets.
However, when all is said and done, stop losses are by no means the only way to protect your trading capital. Combine stop losses with the proper levels of leverage and margin to minimize risks in a comprehensive manner.