A stop loss is a risk management tool that can help protect you against losses when trading. Learn about how to use these tools and when it's best to use different types of stop loss orders.
If you don’t use risk management tools to protect your investments when forex trading, there is every chance your next trade could be your last.
This statement is especially true if you are an inexperienced or beginner trader. While the forex market is the most liquid of all financial markets – meaning forex movements tend to be small – occasionally an event can occur which can see dramatic changes in forex prices. This can result in significant losses to your finances and can be crippling if you are trading with leverage.
For this reason, it is wise to use a stop loss or guaranteed stop loss when trading forex.
Use a stop loss when forex trading for better risk management
A stop loss is a risk management tool that can help protect you against losses when trading. When you open your position, you can include an instruction to your broker to exit your trading position when a certain forex price is triggered. Should this price be triggered, your broker will attempt to automatically sell your open position.
To set a stop loss, you define your stop limit – which is how many pips away from your entry price you wish to have your position closed. Should this limit be triggered, the broker will attempt to close your position to protect the finances in your trading account.
Justin Grossbard of CompareForexBroker says that as a trader, your challenge is to determine the right place to put your stop loss. There is a fine line between giving your stop limit enough space so that natural market fluctuations don’t trigger the stop loss and too much space that you lose more than you should have on a bad trade.
Many traders make the mistake of being too conservative and placing the stop too close to their opening price. This happens because traders make decisions based on emotions or fear of losses rather than on existing market conditions and research.
Volatility in the market
Volatility is how drastically a market’s price changes. Financial markets that have low liquidity have more dramatic price changes, since fewer players with larger sums can have a bigger influence on prices. Since forex has enormous amounts of liquidity, prices don’t tend to change much.
This lack of extreme volatility means a stop-loss works well most of the time when forex trading since the stop limit can be set close enough to the entry point without it being triggered too easily. This means you have protection when the market does become volatile and prices change suddenly, sometimes without warning.
As a trader, you need to be mindful of political, social and economic events that might influence forex prices. For events like inflation or interest rates, you can somewhat prepare for as it is generally known in advance when the latest figure will be announced. But even in these cases, the numbers announced can surprise the market resulting in sudden changes in forex prices.
One example of extreme volatility is the Swiss central bank’s (SCB) decision to weaken the value of the Swiss Franc on Sept 6. 2011. The CHF at the time was closing in on parity with the Euro making it significantly overvalued which led to the SCB announcing, with no warning, that the CHF would be capped to the Euro at 1.20.
Long considered a safe and stable currency for trading, this decision shocked the market and saw the CHF depreciate 8.8% against the Euro and 9.55% against the USD. These falls were catastrophic for traders and brokers, sending many bankrupt or into debt.
While volatility presents an opportunity for profits, in extreme volatility, a stop loss may not be able to protect you.
The problem with a stop loss order
When extreme volatility occurs, chances are that everyone is selling and no one is buying. Without buyers, it can be difficult to exit your trading position. While the broker will still try to close your position, it might be at a lower point than your trigger point. When this happens, it is called gapping or slippage.
An experienced trader, especially one that can afford to take on extra risk, might find using a stop loss adequate for their needs. But if you are a beginner trader or risk-averse, you might wish to consider a guaranteed stop-loss order (GSLO).
What is a guaranteed stop loss order?
A guaranteed stop loss order is similar to a stop loss order. The difference is that for a small premium, the broker guarantees your position will be sold at the stop limit trigger. This means that regardless of market conditions or gapping, you cannot lose more than you are prepared to lose.
While gapping can still occur, since the broker may not be able to close your positions, the broker guarantees you won’t pay more than your stop limit. This means the broker is paying out of their own pocket for anything you lose beyond the stop limit.
To activate this risk management tool you need to purchase a GSLO at the time you open your position. This GSLO has a small premium fee and there are two ways the broker can apply a premium.
The first option is to pay a premium for each unit you purchase. This option gives you greater flexibility as it allows you to change your trigger point at any time. Many brokers only charge the premium if the GSLO is actually applied. Paying a premium, however, can be the more costly option.
The other way the broker applies a premium is to widen the spread. With this option, the more you pay, the further you can set your limit price point from your entry price. The use of a wider spread allows the broker to be precise with your premium so it can be cheaper than paying a flat fee. The catch is that you cannot change your stop limit once you open your position, and you will pay for the stop loss even if you do not use it.
A GSLO is exceptionally useful if you are a beginner trader and need protection from rookie mistakes. And if you are trading with leverage, should the market turn extremely volatile, a GSLO just might save you from losing enormous amounts of money.
Protecting yourself from losses
All traders should consider using a stop loss when trading, however sometimes a stop loss is not enough. If you really want to protect yourself from extreme volatility then a GSLO is a smarter move. This is even more so if you are a beginner trader or cannot offer to lose significant amounts and if you are trading with high leverage.