What is a stop-loss order
A stop-loss is an exit order used to limit the amount of loss that a trader may take on a trade if the trade goes against him. In addition, it eliminates the anxiety every trader inevitably faces when in a losing trade without a plan. No trading system will bring profit on every trade, and losses are natural. Successful risk management means that the losses should be minimized. Stop-loss orders can be an efficient solution for that.
If you’ve decided to use a stop-loss order, it’s very important to find a good place for it. If the stop order is too close to the current price, there’s a risk that the volatile price will hit this order during a false move and then go in the direction you’ve expected it to, so you’ll lose money and earn nothing. If the stop order is too far from the current price, a trader may be vulnerable to a big loss in case the market reverses contrary to their expectations.
The algorithm for choosing types of stop-loss
There are many types of stop-loss orders. Here’s an algorithm for choosing the one that fits you.
Step 1. A discretionary or a system stop?
The position of a stop-loss may depend on whether you are a discretionary or a system trader. In discretionary trading, it’s the trader themself who decides every time which trades to make. A trader places a stop order at a price at which they don’t expect the market to trade. In doing so, they may take into consideration different factors, which may differ from trade to trade.
In system trading, trading decisions are made by a trading system. A trader either opens positions manually in line with the trading system’s signals, or the trading is automated. Here, stop-loss orders are placed according to the risk/reward and win/loss ratios of the trading system.
Step 2. Determine the size of a stop-loss order
Equity stop
The size of this kind of stop is derived from the size of the trader’s account. The most common one is 1% of an account on one trade. For example, if your equity is $1000, you can afford losing $10 on, let’s say, buying EUR/USD. That’s 100 pips on a 0.01 lot (1 micro lot). The upper limit for such a stop is considered to be at 5%. As you may see, this approach doesn’t constitute a logical response to what’s actually happening on the price chart.
Chart stop
The size of this stop depends on the technical analysis of the price action conducted by the trader. Here, one usually identifies the support level and puts a stop-loss order for a long position below it. Technically oriented traders like to combine these exit points with equity stop rules to formulate chart stops. Such stops are often placed at high/low swings.
Volatility stop
The size of this stop depends on the size of volatility in the market. If volatility is high and the price is making big swings, a trader needs a bigger stop in order to avoid getting stopped out. In case of lower volatility, a trader places smaller stops. Volatility can be measured using such indicators as Bollinger Bands.
Time stop
Time stops are based on a predetermined time of a trade. Imagine you are a day trader, you trade only in a specific session, and you close your positions before it ends. You can set a time limit, at which your position will be closed. You can do this using Expert Advisors (EA), i.e. trading robots.
Margin stop
There’s also an aggressive approach to Forex trading, which we don’t recommend all that much. Some traders use the fact that Forex dealers can liquidate their customer positions almost as soon as they trigger a margin call level. A trader may divide capital into several equal parts and put only one on the account. Then, they choose a position size and the potential margin call acts as a stop-loss. Be forewarned that it’s sensible to make such trades only with small amounts of money. Note that it will prevent you from having more than one open position at a time.
Step 3. A static or a trailing stop?
Static stop retains its place once it’s set. Trailing stop is adjusted as the trade moves in the trader’s favor in order to further reduce the risk of being incorrect in a trade.
For example, a trader opens a long position on EUR/USD at $1.3100, with a 50 pip stop at $1.3050 and a 150 pip take-profit at $1.3200. No changes will be made to your order until the profit on your open position exceeds 50 pips. If the euro rises by 50 pips to $1.3150, the trader may adjust their stop up by 50 pips to $1.3100. When you move your stop-loss to the market entry level (as in this case), it becomes a break-even stop: if the price reverses and a trader’s stop is hit, they won’t gain any money, but will lose none either. Each time the price moves 50 pips from the current stop-loss in a trader’s favor, an order will be sent out by the server to change the level of the current stop-loss to be within 50 pips of the current price. In other words, the trailing stop automatically moves your stop-loss order following the price. If the price then turns against the trader, the stop-loss isn’t moved anymore.
Trailing stops are mainly used by traders who like trading trends, but don’t have the opportunity to track the price action all the time.
Trailing stop in MT4
To set an automatic trailing stop in MT4, right-click an order in the terminal window, choose Trailing Stop and pick the desired size of trailing stop. Note that the minimum size of an automatic trailing stop is 15 pips. It’s important that a trailing stop-loss is set in the client’s trading platform and not in the server. If a trader closes the terminal or loses internet connection, their trailing stop order will be deactivated, but the stop-loss order placed by the trailing stop will remain active.
To disable a trailing stop, choose None in the trailing stop sub-menu. If you want to disable trailing stops of all open positions and pending orders, choose the Delete All command from the same menu.
Step 4. Waiting for the results of the trade
Once your stop-loss is set, don’t widen it. Move your stops only in the direction of the trade (trailing stops). You have already made your decision. If the market goes against you and your stop is hit, analyze your trade and see what you’ve done wrong. You don’t need to get overly upset about the failure. What you need is to be successful in your next trade, so move on to the next opportunity.
Summary
A stop-loss is a risk management tool used by members of financial markets to limit potential losses. It is an order placed with a broker to automatically sell an asset when it reaches a certain price level, preventing further losses if the market moves unfavorably. Trading on financial markets involves a high level of risk to capital. In order to reduce risks, it is recommended that you strictly follow the rules of money management and always set a stop-loss.