For example, have you ever been correct with your trading analysis, but got kicked out of your market position because your stop loss level was just a tiny bit overdue? If so, today’s “Q&A Friday” is for you! We have covered a solution to the frustration of a premature stop loss, as well as risk management and trade size calculation techniques. But first things first, what the heck is a stop loss?
What is Stop Loss Order in Forex
You enter a trade with the plans of making money. But guess what, those naughty currency pairs sometimes go completely nuts and disobey every forex rule there is, throwing you out in a losing trade by dancing against your position on the forex dance floor. A newbie who was sleeping during the Invest Diva Education Course could wake up in the morning only to find out his/ her whole account was wiped out because of a market turn. But thankfully, there is a solution to this. It is called a stop loss order.
A stop loss order is an order placed through your broker to get out of a losing position before it’s too late, at a certain, pre-fixed price. It is designed to limit your loss on a position.
The beauty of a stop loss order is that it takes the emotion out of trading decisions and can be especially handy for long term traders (aka investors) or when you are on vacation or cannot remain glued to your screen to monitor your position.
How to Calculate a Stop Loss Order
Your stop loss order largely depends on your risk appetite, your preferable trade size and your account’s leverage. Once you’ve responsibly nailed these down, you can then turn to technical analysis and use forex charts to select an appropriate stop loss order for your forex strategies. Regardless of the direction of your trading position (sell or buy) you can always place a stop loss order for your forex strategy.
Here are the two scenarios:
1- Stop Loss Order in BUY Position
If you are in a buy position, or how forex geeks put it, in a long position on a specific currency pair such as EUR/USD, you’d want the markets to go up and reach you limit order, where you can take profit and live happily ever after (for the remaining of the trading day at least.)
Your stop loss order for this position should be placed in the opposite direction of your preferred market movement, i.e. below your entry level.
One of the best forex strategies for long term investors is using the first key support level as a stop loss order. As we have covered thoroughly in Invest Diva University, you can use a wide range of technical tools to determine support levels; From Fibonacci retracement levels, to chart patterns and indicators such as Ichimoku Cloud.
Fibonacci is one of my most favorite forex strategies when it comes to setting a stop loss order, because if the market was originally in an uptrend (therefore getting you to jump on the trend) and then suddenly changed direction, it most likely is going to test one of the key fibonacci levels especially the 38% or 50%.
Take a look at this losing trade during an uptrend for example:
The trader got into a buy position in the midst of an uptrend, however the currency pair decided they wanted to move back a little bit and visit lower prices again. Breaking below the 23% Fibonacci level (which is normally assigned as a pivot point) the pair decided to go very close to a key support level at 38% Fibonacci. Now that is too much of a loss! And a break below 38% Fibonacci could indicate a trend change and even more losses to come so this responsible trader set a stop loss order a little below the 38% Fibonacci to cut losses short before its too late. An investor with higher risk appetite or in a longer term trading position could set the stop loss order a little below the 50% Fibonacci level.
Do NOT set your stop loss order RIGHT at the support level
As you can see in the forex chart above, the responsible investor has set the stop loss order a little below the key support level. That is because often time, the currency pair dances all the way to the support level, tests it out, but is not able to confirm a breakout, creating a false break, and then heads back up towards our original limit order! Now who wants to get kicked out of a trade prematurely?! I have talked about this more in the video above, and will elaborate more later in this article.
2- Stop Loss Order in a SELL Position
When you are in a short position on a specific currency pair such as AUD/USD, you are betting that Mr. Aussie (Australian dollar) will get weaker and Ms. USA (US dollar) will get stronger, resulting in a down move in the pair. To protect yourself from a sudden change in the trend, you can set a stop loss order using the resistance levels on the pair’s chart.
Just like setting a stop loss order in an uptrend, here we can also calculate the size of our stop loss order based on our risk appetite and technical analysis such as Fibonacci retracement levels as you can see in this chart:
Here, let’s say you got in a sell position at the second pivot level at 23% Fibonacci, however the pair decided to continue its move up and form a double bottom chart pattern. In the case, you can set your stop loss order a little above the 38% or 50% Fibonacci retracement levels.
Do NOT set your stop loss order RIGHT at the resistance level
Just like setting a stop loss order in a buy position, here too you’d want to make sure to give yourself some room to avoid getting kicked out on a false break.
How to Prevent a Premature Stop Loss
One of Invest Diva students, Adebimpe Adenrele noticed her stop loss orders were actually working against her. Here is what she wrote:
First, I’d like to say what a great job you’re doing!!!!! I too am a female engineer (Aerospace Engineer) and pilot. It’s always great to see other women in male dominated industries with style and brains!!!!!! I have a little problem. I have enrolled in your education program and studied all your lessons twice. I usually have winning trades, but for a lot of them, I put the stop loss too close to my entry order. I usually put about 5% on every trade and try and go for at least 1: 2 risk/reward ratio. I usually have a set 40 pip stop loss or 50 pip stop loss and adjust leverage to fit into the 5% risk. I hold my positions for as long as it takes to meet the 1:2 risk reward and try not to tamper with it. It’s so frustrating to be right with your analysis, and then being stopped out because the stop loss wasn’t 5 or 10 pips longer. Please help.
First, I’m so proud of your for calculating your risk/ reward ratio carefully and taking a risk-averse approach to trading!
In all forms of long-term and short-term trading, deciding the appropriate time to exit a position is just as important as determining the best time to enter into your position. Entering a position is less emotional than exiting it, and at the end of the day, its your exit strategy that determines your total profit.
Some forex traders are tempted to ride the tide a little longer, or in the unthinkable case of the market going against you, your heart tells you to hold tight and wait until your losses reverse. That is why setting a stop-loss and limit order prior to entering a position is very important, and I’m glad that you are doing it already based on your risk tolerance.
Watch out for Market Sentiment
The markets can sometimes get too volatile temporarily, which can result in a premature automatic exit. To avoid getting kicked out of your trades prematurely, the best way is to follow up with the market sentiment and keep up with the economic news. While I don’t suggest changing your profit limit order, you can adjust your stop-loss by monitoring how fast the market is moving against you. Only if you are confident with your position and have solid confirmation based on the fundamental and technical analysis, and believe the market will eventually change direction to your favor, then you can loosen up your stop-loss level. To measure the market sentiment, its best to switch into anywhere between the 1-minute, to hourly charts every once in a while.
Trailing Stop Loss Order
Another basic technique for establishing an appropriate exit point is the trailing-stop method. the trailing stop simply maintains a stop-loss order at a precise percentage below the market price in your long position (or above it, if you have a short position). The stop-loss order is automatically adjusted continually based on fluctuations in the market price, always maintaining the same percentage below (or above) the market price. You can then relax and know the exact minimum profit that your position will gain. But before that, You must make sure that you are Setting your trailing-stop based on precise risk tolerance calculations and not based on emotions.
Buyer Beware: Patience is a MUST
Keep in mind that this technique requires the patience to wait for the first quarter of a move which means a number of candles on your trading chart before setting your stops. Here is an example of what you want your road to profit look like based on your forex strategies, and how it really is:
Three Rules for Stop Loss Orders
Now there are times you actually would need to change your stop loss. That is ONLY under extreme circumstances and ONLY if you are cutting your losses SHORTER. Here are three things to remember:
- Don’t let emotions be the reason you move your stop. Like your initial stop loss, your stop adjustments should be predetermined before you put your trade on. Don’t let panic get in the way!
- Trail your stop. Trailing your stop loss order means moving it in the direction of a winning trade. This locks in profits and manages your risk if you add more units to your open position.
- Don’t widen your stop. Increasing your stop only increases your risk and the amount you will lose. If the market hits your planned stop then your trade is done. Take the hit and move on to the next opportunity. Widening your stop is basically like not having a stop at all and it doesn’t make any sense so to do it! Never widen your stop!