Stop-loss orders are the fail-safes of the trading world and the most common means by which traders balance risk and reward without staying glued to their computer screens 24/7. Like the name suggests, stop-loss orders are meant to limit potential losses by automatically exiting traders from their position in the event that price moves against them. If you were to buy a currency expecting an increase in price (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 exit you from your position and limit your losses if the price decreases. If you entered into a short position expecting a decrease in price, you would place your stop in the opposite fashion, above the current market value.
There are different types of stop-loss orders, and each comes with its own trading strategy. In forex trading, the most common stop-loss strategies involve using multiple, incremental stops, using trailing stops, or placing simultaneous stop and entry orders to create a “stop-and-reverse” strategy.
Even in trending markets, there are bound to be small rises or dips in price 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 his or her position, thus 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 in the event that 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 number three, the trader’s lot size would be significantly reduced, with profits becoming incrementally smaller.
On the other hand, a trader may choose to place incremental stop-loss orders simply to sustain his or her 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 loses in the event that the trend moved 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), he or she might place a trailing stop at 10 percent 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. In such a way, 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 places 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 one 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 in question and an understanding of how price tends to move in that market (erratically, sideways, or oscillating up and down between overbought and oversold levels).
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