Minimizing Risk with Stop-Loss Orders

When you’re considering diving into the forex market, there are a lot of different aspects and factors to consider. This can sometimes make it easy to forget some crucial elements that are going to be pivotal to any trading success you’ll have. One element that is sometimes overlooked—almost criminally so—is the stop-loss order. The following takes an in-depth look at stop-loss orders, addressing why they’re of the utmost importance when it comes to minimizing risk while trading forex.

What Is a Stop-loss Order?

Essentially, a stop-loss order (or “stop order” and “stop-market order” as it’s otherwise known) is placed with a broker, who closes a position when the related currency pair reaches a certain price point, limiting the loss a trader experiences. Traders will generally use stop-loss orders with long positions, but it’s important to consider them as protection for short positions as well. It’s worth thinking of a stop-loss order as a safety net, which can become active as a means to protect you from a trade that could potentially harm your forex portfolio.

How Does a Stop-loss Order Work?

Stop-loss orders can—and often will—remove the emotion that inherently comes with trading decisions, as well as being useful if a trader is on vacation or cannot monitor his or her position. However, it’s important to note that a stop-loss order is not guaranteed, especially when trading in times of extreme volatility, or if it gaps down or up in price. When a trader uses a stop-loss order in long positions, the order to sell is activated when the pair trades under a specified price, meaning that the order gets filled at the next price available. This is efficient when the market is orderly. In the event that the market falls quickly, however, investors will see their orders filled below their specified price.

Example: If you bought the EUR/USD at 1.3230, you could set a stop-loss order at 1.3200 to minimize your loss.

Pivotal for Minimizing Risk

The draw of the stop-loss order is its affordability, as it really doesn’t cost anything to set up. Only after the stop-loss order has been activated is your regular commission charged, which essentially means that it’s a cost-free form of insurance. However, we do use the term “insurance policy” loosely. There is a lot of emotion involved in forex trading—investors tend to attach emotion to certain currencies, believing that they’ll “turn around” if given the chance. A stop-loss order removes the emotion, helping traders avoid delay and procrastination as losses increase.

All investors should know the reasoning behind holding a currency—whether it is based on technical analysis or otherwise—as it will differ from trader to trader. For example, a value investor’s reasoning will differ when compared to a day trader, growth investor, or any other type of trader. Strategies only work if you stand by them, meaning that if you’re a steadfast hold-over-the-long-term kind of trader, a stop-loss order is generally useless for you.

What all traders need is confidence, in their strategy and in themselves. Stop-loss orders can assist traders with that by helping them stay the course without involving emotion. It’s also important that investors know that stop-loss orders don’t guarantee profit—that’s up to the trader and the decisions he or she makes. If a trader has a stop-loss order and still makes poor decisions, all a stop-loss order will do is cause that trader to lose money at a slower pace.

The Uses of a Stop-loss Order

Though stop-loss orders are traditionally used, as they’re so aptly named, to stop losses, they can also be used to protect profits. This can be called a “trailing stop” and is used when the order is set at a percentage level instead of a specific price. Thus, it will adjust with the fluctuations of the market. This allows traders to take advantage of unrealized gains or situations when a currency goes up but a trader hasn’t sold yet. 

Conclusion

The stop-loss order is an incredibly simple tool that is sometimes ignored by forex traders, and this is a mistake. Almost all trading styles can see benefits from this tool, whether you seek to prevent losses or safeguard profits. As mentioned before, you should consider a stop-loss order to be like an insurance measure, in the sense that you hope you’ll never need it, but you’re happy to have it when you do.