Stop-loss orders are the fail-safes of the trading world. They’re the most common way for traders to balance risk and reward without having to stay glued to their computer screens 24/7. Stop-loss orders can help investors minimize losses on new positions.
Interested in learning more? Let’s take a closer look at this type of order.
What are stop-loss orders?
As the name suggests, stop-loss orders are meant to limit potential losses by automatically exiting traders from their positions if a price moves against them. If you were to purchase a currency expecting a price increase (called “taking a long position”), then you would place a stop-loss order to sell and exit your position directly below the current market value.
This stop-loss order would only be triggered if the price drops below your stipulated threshold—in short, it will automatically exit your position, limiting your losses if the price declines. If you entered into a short position expecting a price decrease, you would place your stop in the opposite fashion, above the current market value.
What are the benefits of stop-loss orders?
The best part about stop-loss orders? Unlike a majority of the finer things in life, they’re free. Seriously, a stop-loss order costs absolutely nothing to implement. A commission is added only after the stop-loss price has been reached and the stock is sold.
Stop-loss orders are also great for traders who prefer a more hands-off approach. With stop-loss orders, you’re not required to track a stock’s performance each day. This also prevents emotional decision-making when it comes to buying and selling stocks, helping you stay the course and preventing irrational choices that could lead to loss.
Learn more about risk management.
What are the risks of stop-loss orders?
Like any type of trade, stop-loss orders aren’t foolproof. Establishing one doesn’t minimize a trader’s loss to just the amount between the predetermined sale price and purchase price. If a publicly traded company posts earnings that are lower than expected after the market’s daily closure, the value of its shares could still dip below the stop-loss price.
Stop-loss orders can also lead to a stock sale if a stock’s price drops beneath its trigger price before recovery. Volatile market conditions can also bring risks. During market declines, hedge funds may attempt to exploit stop-loss orders. This is often referred to as stop hunting, where traders short stocks that are already dropping in value to move prices lower. Then, the same investors purchase these stocks to earn a profit from the anticipated rebound.
Even in trending markets, there are bound to be small rises or dips in prices that go against the overall market trend. For example, the trend line connecting price peaks in the graph shown reveals a strong downtrend, with the price moving from the upper left quadrant of the graph to the lower right quadrant.
In a strong downtrend, long-term profits will favor traders who hold a short position (i.e., those who bet on the fact that a price will drop). That said, there are still periods when a price increases, as illustrated by the seven red arrows in the graph. If traders wish to trade with the overall trend, they will likely aim to hold onto their short position through small surges in price. As long as the price continues to fall more profoundly than it rises (without breaking the previous trend line), the long-term profits will inevitably outweigh the losses.
But sustaining any amount of loss is inherently risky, and the ratio of risk to reward incurred by traders is influenced by their lot size as well as their position. As a means of mitigating risk and locking in profits, traders will often break a larger position into multiple, partial stops.
To lock in profits with a short position, a trader would place partial profit-taking stops at incremental values below the current market price. When the price passes each stop threshold, it will partially exit the trader from their position, locking in a portion of earnings while keeping the trader in the trade with a smaller lot size.
Although decreasing the lot size will inevitably curb the potential profit margin, it will also mitigate risks if the trend changes. Looking at the next graph, imagine that the trader had placed all three profit-taking stops when entering into a short position at the top left quadrant (before knowing exactly how the price would move). Each stop is designed to lock in profit at different stages of the downtrend. The circled point on each successive stop is the point at which the stop order was triggered by price movement. By stop No. 3, the trader’s lot size would be significantly reduced, with profits becoming incrementally smaller.
Conversely, a trader may choose to place incremental stop-loss orders simply to sustain their position and reduce losses rather than lock in profits. In that instance, a trader in a short position would place multiple partial stops above the current market price to stay in the trade but reduce losses if the trend moves in an unfavorable direction. This strategy is more commonly used by traders who are expecting a trend reversal and want to allow time for the reversal to transpire before completely exiting their position.
Unlike fixed-value stop orders, trailing stops automatically change position in relation to price movement. This allows traders to remain in a trade, mitigate risk, and protect profit margins without necessarily reducing their lot size. Rather than specifying a value at which to exit a position, trailing stops typically use percentages to dictate how far away from the current market price a stop should be placed.
As depicted in our third graph, if a trader enters into a short position (anticipating a strong downtrend), they may place a trailing stop at 10% above the current market price. As the price continues to fall, the position of the value of this stop will also fall, remaining the same relative distance away from the current market price. Trailing stops allow traders to remain in a trade but keep their risks relatively static as the trend moves away from their starting point.
A stop-and-reverse strategy involves two types of orders: a stop-loss order and an entry order. Traders using this strategy create a stop at a certain loss threshold that will exit them from their position when and if the price reaches that threshold. At that same value, traders simultaneously place an entry order to open a new position (opposite their original order) and place a stop in the opposite direction. This mitigates losses by exiting traders from their original position while simultaneously attempting to capitalize on the current trend.
Some brokers allow stop-and-reverse orders to be processed together as a single order, whereas others require traders to place the initial stop order and then create a new order to reverse their position and place a new stop. For this strategy to be effective, traders must have a sophisticated knowledge of the market and an understanding of how prices tend to move in that market (erratically, sideways, or oscillating up and down between overbought and oversold levels).
What are the tools of the trade?
Forex traders use many different types of tools to help them trade; some can help identify break and support lines or entry and exit points. These technical tools are known as indicators, and there are hundreds available across trading platforms.
Access Valutrades’ seven must-have forex trading indicators for our MT4 platform now. From inside and outside bars to three-strike pattern indicators, these tools can help you identify setups and become a more informed trader.
The information provided herein is for general informational and educational purposes only. It is not intended and should not be construed to constitute advice. If such information is acted upon by you then this should be solely at your discretion and Valutrades will not be held accountable in any way.