The Best Forex Stop Loss Strategies
One of the most important elements in a successful forex trading strategy is knowing how and when to exit a trade and take a profit. As you may already know, there are a lot of factors which can influence the markets, and it’s not always possible to make the right call 100% of the time.
However, there are some fantastic opportunities to be taken advantage of, especially with instant forex funding available. The key is to manage your capital in a way which mitigates against risk.
One of the most effective tools to help you manage risk and minimise losses is the stop loss. Here’s a look at what they are, how to use them, and the best way to incorporate them into your forex trading strategy.
What are stop losses?
Imagine you are on a blind date in a swanky cocktail bar. After a drink or two, you decide that this isn’t the one for you, but your date has a taste for the most expensive beverages on the menu, and you aren’t sure who’s going to pick up the tab. You decide it’s time to bail before the evening turns into a big costly waste of time.
That’s basically how stop losses work. You have worked out that you are in a losing situation, and the best strategy is to cut your losses and leave. It saves you hanging around in the hope that things might improve, and saves you from doing some serious damage to your account.
Like the world of dating, the forex markets can be an unpredictable and volatile place. If the markets are moving against your initial predictions (which they sometimes will), then a stop loss can be determined in advance to exit the trade at a specified point below the entry price. This will prevent you from incurring sweeping losses in the worst-case scenario.
Stop-loss orders can be automatically triggered to sell the currency pair when the pre-determined price is achieved. The contract for the stop-loss is executed at the market price, which can be higher or lower than the stop loss price. The stop loss order can be adjusted after the position has been opened, if necessary.
Why do you need to use stop losses?
You might be thinking, well I’d rather just judge for myself when to exit a trade, and not go through the hassle of deciding in advance and setting a stop loss order. There are many reasons why this is really not a good idea, and even very experienced traders tend to avoid it.
Leaving it to the last minute may feel as though it is all part of the thrill of the chase, but this is not what successful forex trading is made of. 99% of successful traders will tell you that making steady profits is all about being cautious and implementing a well thought out strategy in advance.
Even the coolest of heads can make a poor decision under pressure, which is led by emotion rather than logic. When it comes to managing capital, the natural human instinct is to drive for bigger profits (some might call this greed) and avoid losses (which is driven by fear). However, these primal instincts can lead to ruinous trading decisions.
Without a pre-determined exit strategy, you will always be facing the temptation to err on the side of caution and exit too early, thus losing out on a good profit. On the other hand, you may be tempted to hold out for a bigger profit, and incur a thumping loss if the markets turn suddenly.
There are plenty of mind management techniques you can employ to help to stay in charge of your emotions and keep your cool when trading. It’s important to read up on the basics of trading psychology, no matter how good your technical knowledge is. However, psychological tactics should be backed up with some solid strategy.
How do you use stop losses?
There are different types of stop losses, and the one you use may depend on the amount of capital you are trading with, the current market conditions, and your level of experience and technical strategy.
Knowing when to exit a trade is a crucial skill, and the key is to avoid uncontrolled losses. One of the first things to decide is what your risk tolerance is. This means the amount of money you are prepared to lose on each trade. To decide this, you need to take a look at your personal finances and decide how much breathing room you have.
If you have a steady income and savings, with no major financial obligations, then you will probably be in a position to take a few losses as you learn to trade and turn stable profits. You are likely to be in position to invest more in your trading account, which can carry bigger positions and are more robust in adverse market positions.
On the other hand, if you have an unpredictable income, and/or heavy outgoings, then you are going to need stricter controls, and you also need to guard against making pressured or aggressive decisions which will spoil your trading mindset.
Look to strike a good balance between being able to sleep at night, and trading with enough risk tolerance margin to make it worthwhile. The standard amount of capital to risk per trade is 1% or 2%, although more experienced traders or those with a high risk tolerance may risk as much as 5% or even 10%.
You could set your stop loss simply based off the percentage point of your account, such as 2%. However, this is a very crude method of using stop losses, and by far the least effective. This is because it can never take into account the current market positions, and while you may limit losses, taking profits will be more or less a matter of chance.
Using support and resistance levels to set a stop loss
As you have seen, setting a stop loss is not as simple as it first appears. One of the most common strategies is to set the stop loss in accordance with support and resistance levels, which help you to understand price action. This will help you to determine when the markets are in the most favourable position for you to exit a trade.
Like all financial markets, the forex market is moved by supply and demand. This can be influenced by many factors, such as seasonal demand for goods, or the GDP of a particular country, especially the major economies such as the US and the Eurozone. It can also be affected by geopolitical events, such as elections, wars, and natural disasters.
Support and resistance chart these movements, which can be on any time scale, from hours, days, weeks, months, or even years. Some people like to think of the movement of support and resistance levels as like a rubber ball bouncing across the floor. There will always be an upward or downward trajectory, and the ball will travel at a varying rate of velocity.
If the market is on a downward trajectory which is soon expected to pause, this is known as a support phase. It’s a sign of optimism that conditions are about to improve. A resistance zone occurs when an upturn is expected to pause because of unfavourable conditions, such as an oversupply in the market.
Traders will use support and resistance levels to anticipate which way the market is about to turn, so they can make a profitable trade, or sell off currency pairs which they expect to soon drop in value. Sometimes, the trend will break through the pause and continue on its current trajectory. On the other hand, it may travel sharply in the other direction.
Therefore, setting stop losses at a point beyond the levels of support and resistance is a common forex trading strategy. At the very least, they can help you to break even when you miss your profit targets, and at best, they provide a tool to help you maximise the amount of profit that you take.
How to use Average True Range
Once you have got to grips with using support and resistance levels to help to determine your stop loss position, you can look at more complex technical strategies. One of the most used market indicators is Average True Range, or ATR. This is a way of measuring the volatility in the markets over a set period of time.
By measuring volatility, it allows you to take advantage of breakouts, and also to set your stop losses at the optimum levels. ATR allows you to look at the average range of a currency pair over a variable time period, which you can adjust to your choosing.
These are just a few of the ways that you can use stop losses on your account. How you use them will depend on how much experience you already have, and the account size you are operating with. They are intended to help you manage risk and mitigate against losses, which are the pillars a solid trading strategy is built on.