What is Stop-loss and How to Use it in Trading

What is Stop-loss and How to Use it in Trading


23 May 2019

Setting a stop-loss order is one of the most important and mandatory actions when trading on Forex. The conditions of placing a stop order must be spelled out in the algorithm of each professional strategy. Otherwise, this strategy cannot be considered complete. However, some beginners who have just come to Forex, do not fully understand what stop-loss is and why it should be exposed. In this article, we will examine all of the main points related to a stop-loss order and consider several effective strategies for placing stop orders.

Table of Contents

Stop-loss Definition
Why Use Stop-loss in Trading and How to Place it Correctly
How to Calculate Stop-loss
Types of Stop-losses
Stop-loss Strategies
Conclusion

Stop-loss Definition

Stop-loss is an auxiliary order, which is set to protect a trader from serious losses in a particular transaction. 

If the price goes in the wrong direction from which a trader expected movement, and the trade becomes unprofitable, the stop-loss helps save the stock. 

When the price reaches the stop-loss level, the transaction closes automatically; a trader is able to save all the rest of the money and can begin developing a plan for the return of lost funds. A trader himself assigns a stop-loss level before opening a trade. Stop-loss is always tied to a certain price (with the exception of stop-loss on time, this case will be discussed later).

Stop-loss order on a chart

Stop-loss order on a chart.

For example, if a trader opens a EUR\USD deal to buy at a price of 1.2500, then the stop-loss can be set at level 1.2490. It means that if the price goes down, and a trader starts to suffer losses, then the loss will be a maximum of 10 points. After that, the transaction will be closed, and a trader may make a new decision. For example, open a transaction for sale, if the trend of price reduction continues.

Why Use Stop-loss in Trading and How to Place it Correctly

Stop-loss must be set in order to minimize and control possible losses during trading. Even the best trading strategy periodically gives false signals, and opening trades with these signals leads to losses. Stop-loss helps to reduce these losses to a minimum, which allows a trader to quickly compensate for the lost funds and again get a plus.

Stop-loss can be set both at the time of opening the transaction, and later. It is better to place a stop order immediately because sometimes the price can make a sharp jump and move 20-30 points in just a few seconds. 

If such a jump occurs in the opposite direction that a trader was expected, stop-loss will reduce losses many times. If a sharp price fluctuation occurs immediately after the opening of the transaction, in which the stop-loss was not set in advance (for example, a trader decided to do it a little later), the funds will be, to some extent, defenseless.

How to change stop-loss

How to change stop-loss.

In practice, it is very easy to set stop-loss. For example, in the popular MetaTrader 4 trading terminal, this can be done in at least two ways:

  • When opening a new order, enter the stop-loss level in the price level at which you would like to stop-losses and close the deal.
  • When the deal is already open, you need to hold down the left mouse button by hovering the cursor over the order line and drag the line in the opposite direction to the open deal. For example, if you have opened a purchase transaction, you need to drag the line downwards, or upwards for a sale.

How to Calculate Stop-loss

There are many ways to calculate the size of the stop-loss for each specific transaction. In most professional trading strategies, it is already written, under what conditions, and at what distance from the opening price of a transaction, a stop should be placed. There are also several universal tactics for calculating and installing a foot – we will discuss them later in this article.

There is also one well-known rule that is recommended for all traders and for beginners in particular. The rule is this: losses in each individual transaction should not exceed 2% of the total capital. Based on this, you can calculate the stop-loss.

For example, a trader has a capital of 10,000 dollars and opens a EUR/USD transaction with a volume of 1 lot. The calculation is as follows:

  1. 1 lot EUR/USD = 100 000 EUR, one point of price movement will “cost” 10 dollars.
  2. 2% of the capital of a trader is 200 dollars.
  3. 200/10 = 20. So, a trader can afford a “drawdown” of a maximum of 19 points before forcibly closing deals and fixing a minus. The stop order must be placed at a distance of 20 points from the opening price of the transaction.

Types of Stop-losses

Types of Stop-losses

There are at least three types of stop-losses on Forex, each of which works differently and allows a trader to rely on a different result.

Basic Stops

The standard stop-loss that most brokers offer on their platforms works as follows:

  1. A trader places a stop order at a specific price.
  2. When the real market price reaches this mark, the transaction closes.
  3. Stop-loss is set once and remains unchanged (if a trader does not change it himself, manually).

The main drawback of such a stop-loss is that it is subject to "slippage”. If the price makes a sharp jump of several points and the stop-loss "jumps", the transaction will close, not on the level indicated by a trader, but only on that level where the price jumped to. It means that a trader can lose a few points more than he allowed for according to this plan.

Guaranteed Stop-loss

Guaranteed stop works on the same principle as the base, but it has one significant difference. When a guaranteed stop-loss is triggered, the transaction will always be closed precisely at the price set by a trader.

In other words, the guaranteed stop is not subject to slippage. The broker undertakes to close the transaction at a certain price and assumes all the risks associated with volatility. However, for such a guarantee, the broker may assign an additional commission.

Trailing Stop

A trailing stop is different from the base and guaranteed that it can move after the price stops. 

The trailing stop is not set at any particular price point. It is tied directly to the current price – for example, it might be set at a distance of 20 points. 

If the price moves in the necessary direction a trader plans for, the trailing stop “pulls” behind it, always remaining at a distance of 20 points. If the price turns in the opposite direction, the stop-loss remains in place.

Using a trailing stop, a trader can not only ensure against excessive losses, but also protect part of the profits. A trailing stop can be used as a method of taking profits, instead of the standard Take Profit.

Stop-loss Strategies

If your trading system does not provide for any specific conditions for placing a stop order, you can use one of the universal strategies.

Percent Stop-loss

The percentage stop is set in a certain relation to constant values, such as the amount of capital or the level of Take Profit. 

This involves placing a stop order, based on the size of the capital, we have already considered earlier. Recommended ratio of stop loss to capital is 2:100 (i.e., 2%). For example, with a capital of $ 10,000, For example, if your capital is $ 10,000, it will be correct to put a stop loss at about $ 200. Binding to take profit is usually 1:2 or 1:3 – that is, the planned profit must be 2 or 3 times higher than the allowable loss.

AdvantagesDisadvantages
✓ Ease of use✗  Does not consider volatility and key levels
✓ Profit more or less✗  Market maker easily knocks out the “stop”

The advantages of such tactics are obvious – the stop level is easy to calculate, and the profit in one transaction will be many times greater than the loss. However, it is far from reasonable in every situation to set a stop-loss with such tight binding and to ignore the objective situation in the market. 

If the stop-loss set in a ratio of 1:3 to take profit is in front of a key level, the probability that the price will affect such an order is very high. In this case, the frequency of closing trades using stop-losses can negate the profit obtained due to the relatively large take profit.

Volatility Stops

Setting a stop-loss based on volatility is an effective technique since in this case a trader can take the stop beyond the main range of price fluctuations and ensure that the order that will be accidentally “touched”.

Stop-loss by ATR indicator

Stop-loss by ATR indicator.

To determine volatility, simple indicators like Standard Deviation (SD) or Average True Range (ATR) are most often used. The calculation of the stop-loss is as follows:

  1. A simple moving average (SMA) is set on the chart to determine the average price indicator.
  2. Next, an ATR or SD indicator is installed to determine volatility.
  3. To determine the price for a stop order, the last ATR (SD) value multiplied by 2 must be subtracted from the last SMA value.
AdvantagesDisadvantages
✓ It takes into account the real market situation✗  Indicator readings may be delayed
✓ The amount of allowable damages is relatively small✗  The market situation, like the level of volatility, is changing rapidly, and the stop-loss becomes irrelevant

Stop-loss on volatility may be the best option at the time of exposure, but its relevance decreases with each new candle on the chart. For medium and long-term trade, this method is not recommended.

Chart stop

When installing a stop-loss on the schedule, key levels (support and resistance), as well as local extremes are taken into account. They need to be determined before setting a trade open and setting a stop. This tactic to set a stop-loss is most effective when trading according to technical analysis. In this provision, the definition of levels, extremes, and other important elements occur in the general analysis of the graph.

Stop-loss should be set beyond the nearest level or local extreme. If the stop is set at the level itself, or in front of it (relative to the price), the likelihood that it will be affected by random fluctuation increases.

AdvantagesDisadvantages
✓ It takes into account the real market situation.✗  Stop-loss level may be too high relative to take profit
✓ The trader has a choice✗  Market maker easily tracks key levels and extremes

Stop-loss by time

Stop-loss of this type is set based not on price indications, but on time parameters. For example, a trading strategy may require a trader to close a deal at the end of the day, regardless of the outcome.

This stop-loss is not very popular and is used in rare cases.

AdvantagesDisadvantages
✓ Such a stop is difficult to track✗  The real market situation is not taken into account
✓ The trader always knows when the transaction will be closed✗  The trader has to close the deal manually

Conclusion

Stop-loss is an important element of the trading system, it makes trading more secure and controlled. It can be difficult for a novice trader to understand all the nuances of placing a stop-loss immediately, so the best option would be to start with mastering the simplest techniques.

For trading training and working with stop-loss, the Libertex trading platform is perfect. 

Unlike other trading platforms, it is extremely simple, and even a novice who has no trading experience can easily navigate its functionality. In addition, you can open a demo account for free at Libertex and practice on it as long as it takes for you to master the platform.

For all its simplicity, Libertex is quite functional, has a large selection of assets and tools for analysis. In this terminal, a novice trader will be able to try out all the strategies for placing stop-loss and, after evaluating the results, make an optimal selection.

Also, the Forex Club broker offers its traders MetaTrader 4 and MetaTrader 5 trading terminals as well. These are more professional, but also more complex platforms for experienced traders. In MT4 and MT5 there are more technical possibilities for setting a stop loss, and there is also the possibility of opening a free demo account for training.

 

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