How to trade using stop loss orders

Learn how to use a protective stop loss order and what is a trailing stop to perfect your Forex trading skills and avoid unnecessary losses.

On 23 June 2016, voters in the United Kingdom went to the polls to decide on the future of the UK in the European Union. As the day ended, the results shocked many people as the UK — the second largest economy in the EU — had just decided to leave the biggest free trade agreement in the world. When markets opened, the pound had one of the biggest plunges in history. This is because before the vote, most polls showed an outright win for the Remain-in-Europe side. To the few traders who had foreseen the Leave campaign winning, 27 June was a good day to them. To the majority who had followed the polls’ numbers, it was a difficult day. Stories were written about traders who lost their entire funds by buying pairs with the pound as the base currency. The Brexit vote is a good example of the risk traders expose themselves to every day. To minimise the impact of these risks, experienced traders use a combination of methods. For example, some adjust their leverage ratio when they expect major releases. Others focus on opening small trades while others stay out of the market during periods of high volatility.

Another common method for reducing risk is the use of stop loss order. A stop loss is a tool found in most trading platforms to help traders manage risks. It does this by stopping the trade automatically when a certain level is reached even when the trader is not present. This usually specifies the maximum amount of money a trader is comfortable losing. By using a stop loss, traders avoid being in a situation where a single trade wipes away their previous wins.

Stop loss order works by exiting the trade automatically when a certain level is reached even when the trader is not present.

 How to place a stop loss

To place a stop loss, traders should do a few things. First, they need to calculate their risk-reward ratio. This is a simple ratio that specifies the maximum amount of money they are willing to lose and the maximum profits they are looking to gain. While there is no consensus on the best risk-reward ratio, an ideal ratio for beginners is 1:2. In this, a trader is risking $1 to make potentially $2.

To determine the ideal risk-reward ratio, experienced traders use a simple formula that factors in their winning rate. This formula assumes that the trader’s winning rate will be retained in future trades. The formula is: E = ( 1 + ( W / L ) × ( P − 1 )

Where: P is the winning rate, W is the size of the average win, and L is the size of the average loss.

For example. If a trader makes 10 trades, wins on 6 and loses on the other four, the percentage of the winning ratio is 60%. If the six winning trades bring $3,000, it means the average win is $500. If the losing trades lost $1,600, the average loss is $400. By applying these numbers to the above formula, the answer will be 35% or $0.35. This means that this trader would be relatively safe by using a 1:3.5 ratio.

When placing a stop loss order, Kathy Lien, the author of Day Trading and Swing Trading the Currency Market recommends that traders use two ways. In the first method, they should use a two-day low method. In this, they should place a stop loss approximately 10 pips below the two-day low of the pair. For example, if the low of the GBP/USD’s most recent candle was 1.1500, and the previous low was 1.1400, the stop loss should be placed at about 1.1390 if a trader is placing a buy trade.

The second option she recommends is using the Parabolic Stop and Reversal (SAR). This is an indicator found in most trading platforms including MT4. The indicator places a dot on the chart where the stop loss should be placed when the trader opens a long trade.

Other options such as using the Fibonacci Retracement levels, Bollinger Bands, and other technical indicators have been suggested. A trader needs to find a formula that works, test it, and apply it in their trades.

Trailing stop

New traders stop at the stop loss level. Experienced traders use the concept of a trailing stop loss to minimise losses and maximise on the opportunities. In this, a stop loss is not placed on a single level. Rather, it is placed on a certain percentage below the market price of an asset. If the trade moves up, it drags the stop loss with it, thus protecting the profits that have been made.

This concept is important because certain times a profitable trade will reverse before hitting the take profit level, thus wiping away the gains.

For example, if you are trading CFDs on stocks and you buy a stock that is trading at $10, you will benefit when the price moves up. But, since you don’t want to lose more than 5% of your capital, you want to continue taking advantage of any upward movements. So, you place a stop loss that automatically stops the trade when the trade falls below 5% of the market size.

In this example, the stop loss will be triggered when the stock CFD falls below $9.50. If the trade moves up to $20, the stop-loss will move up with it, thus locking in most of your gains.

Final thoughts on stop loss orders

Traders should have a stop loss whenever they open a trade. This helps protect your accounts if the trade goes against their favour or when there is major unexpected news. In the Brexit scenario highlighted above, most traders who believed that the stay side would win lost money. Among them, the losses of traders who had a stop loss were minimal.