How to use Stop Loss and Trailing Stop Orders in Trading

Stop-loss

At some point during a trade, you’ll decide it’s time to take profits, or if the trend reversed, to cut losses when they’re small. To do that, you’ll need to use one of the exit position orders. This article will explain how to protect and maximize gains using stop-loss and trailing stop orders. 

First, remember that the main difference between exit orders is whether you’re closing a losing trade to cut your losses or a winning trade to take profits.

What is Stop-Loss - What is Trailing Stop

As the name implies, stop-loss orders are pending orders that automatically close your position to stop a loss from getting any worse than your predetermined maximum amount you were willing to risk. That maximum may be determined by either:

  • Risk management considerations: broken price support of some kind (many exist as we’ll soon see) or other indications that you were wrong about the price direction.  
  • Money management considerations: you don’t want to lose more than 1 to 3 percent of your account on any given trade.

There are two basic kinds of stop-loss orders:

  1. Fixed or Simple Stop Loss: As the name implies, this order automatically executes when a fixed predetermined loss is reached or if the market gaps past it, and the loss is exceeded. Any good forex trading platform like MetaTrader 5 - MT5 will allow you to set that loss in terms of pips, cash loss, or percentage loss from your entry price. 
  2. Trailing Stop Loss: As the name suggests, this kind of stop-loss order trails or follows the price as it moves further in your favor, and it automatically closes your position after the currency pair price moves against you by a fixed number of pips, cash amount, or percentage change in price against you. Thus the trailing stop loss not only to limits losses but also locks in gains from winning trades that have started to reverse against you by more than what you believe to be normal random price movements or “market noise.”

Stop-loss orders area key part of risk management. We can enter them in advance and have our trading system automatically cut our losses. They help keep emotion out of our forex trading

For a given position size and leverage, you limit your maximum loss per trade through your stop-loss settings. The following rules on stop loss setting assume you’re entering near strong support because if you aren’t, you shouldn’t even consider entering the trade. If the trade moves against you, that nearby support is quickly breached and you have a trading signal to exit before a small loss becomes a large one.

Continue reading or play around in a risk-free demo forex and test the exit orders in real market conditions.

Where to Set the Stop Loss: Two Criteria

When setting your stop-loss order, you’re always striking a balance between two conflicting criteria:

1. The stop-loss price is close enough to your entry point so if it’s hit, the loss doesn’t exceed 1 to 3 percent of your account value, as noted previously.

2. It’s far enough away from your entry point and the likely support level so it doesn’t get hit by normal random price movements and close your position before the price has had time to move in your favor. Rather, it’s triggered only by price moves that are big enough to suggest that you were wrong and overestimated the strength of a given support zone, and now a loss is more likely than you thought. It’s time to close the position before a small affordable loss becomes a large one. There are different ways to determine the normal or average price movement to expect during a given period. Some manually determine the average or typical candle length over a given period. Some will use a certain percentage of the range as determined by the Average True Range (ATR) indicator. Price volatility varies with market conditions and time frame as must the distance from the entry point to stop loss.

Viewed from another perspective, setting stop losses means striking a balance between:

  • Less frequent but larger losses from wider (or looser) stop loss settings: The farther your stop loss from your entry point, the larger the losses on losing trades relative to your gains from winning trades. However, you have less chance of having your stop loss hit before the price starts to move in your favor (being “stopped out”). The main advantage of this approach is a higher percentage of winning trades (which you may need for encouragement), at least when you’re right about the ultimate price direction. The main disadvantage is that you risk too many large losses and lower profits compared to the following approach to setting stop losses.
  • More frequent but smaller losses from tighter (or narrower) stop loss settings: The closer your stop losses to your entry point, the smaller the losses on losing trades relative to your gains from winning trades. However, you’ll have more losses from being “stopped out” on trades that would have ultimately worked, because your stop loss will be hit more often before the price has had time to move in your favor.

Use a Trailing Stop to Protect and Maximize Gains

Though your initial plan should be to exit near likely resistance, remember that you have the option of using a trailing stop.

Instead of fixed stop losses, use trailing stop loss orders whenever possible because they give you the best of both worlds, the protection of a regular stop-loss without the limitations of a fixed exit point. Until price retraces and hits the trailing limit, you ride the move as high as it goes. Once your trailing stop is above your entry point, the only question is how much you’ll profit. As part of our drive to maintain a high risk-reward, we try to get even better than 1:3 risk-rewards when we can. Using trailing stops allows us to get those extra gains. These big winners help compensate for losing trades and for winners in which you were forced to exit with minimal gains to avoid a loss.

It isn’t always practical to use a trailing stop when you begin a trade. In these cases, you simply change the switch from a fixed to a trailing stop-loss once the trade has moved a certain number of pips in your favor, at a minimum so that your loss would be less than your initial fixed stop loss.

ATR Trailing Stop Loss

ATR is commonly used as a trailing stop loss. At the time of the trade, look at the current ATR reading. Place a stop loss at a multiple of the ATR. Two is common multiple, meaning you place a stop loss at 2 x ATR below the entry price if buying, or 2 x ATR above the entry price if shorting.

The stop loss only moves to reduce risk or lock in a profit. If long, and the price moves favorably, continue to move the stop loss to 2 x ATR below the price. The stop loss only ever moves up, not down. Once it is moved up, it stays there until it can be moved up again, or the trade is closed as a result of the price dropping to hit the trailing stop loss level. The same process works for short trades. The stop loss is only moved down.

For example, a long trade is taken at $10, and the ATR is 0.10. Place a stop loss at $9.80. The price rises to $10.20, and the ATR remains at 0.10. The stop loss is now moved up to $10, which is 2 x ATR below the current price. When the price moves up to $10.50, the stop loss moves up to $10.30, locking in at least a $0.30 profit on the trade.

More Capital Allows Wider Stop Losses

A larger account means:

  • You can afford to set stop loss settings that are wide enough to avoid getting prematurely “stopped out,” yet still only risk 1 to 3 percent of your capital, because you have more capital to risk. That means there are more trades available to take that have entry points that are both close enough to strong support and only risk 1 to 3 percent of your capital.
  • You can afford the wider stop losses needed to ride the more stable longer-term trends via longer-term positions. As noted previously, the forex market produces many stable long-term trends. However, the longer you hold a position, the larger the normal price swings and the farther the stop loss must be from your entry point. For example, a pair may have average daily price swings of 50 points, but weekly or monthly average price swings could be many times larger. A bigger account allows you to set those stop losses far enough from your entry point (near strong support, of course) to ride the wider short-term fluctuations within the more predictable long-term trends. In sum, a larger account allows you a wider choice of trades in any time frame, and also offers more chances to ride the most stable, predictable, and safer trends that are the basis of lower-risk trading.

Not surprisingly, studies suggest certain minimum account sizes increase your chances of being profitable.

Final words about Stop Loss and Trailing Stop

Because support and resistance levels occur over areas or zones rather than precise points, selecting entry, exit, and stop-loss points can be stressful because you’re never sure if you’re right. To lower the risk and stress level, many find it helpful to enter and exit positions in stages.

For example, if your planned position is two mini account lots, you could take profits on one lot at a more conservative price, and leave the other mini lot to continue with a trailing stop loss. If your trailing stop loss is set to trigger at no worse a position than your first exit point, you at least lock in a smaller profit as a worst-case scenario. This first exit should bring profits on that first lot that are at least equal to the loss risked by your trailing stop, thus allowing a 1:1 risk-reward ratio on that lot. Set your trailing stop so at worst it triggers at your initial exit and you lock in at least a modest profit and a 1:1 risk-reward ratio on the trade. If price continues to run higher, the second lot gives you added returns though not as much as if you’d let both lots run with a trailing stop once the first exit. Safety usually comes at a cost of lower returns. Taking partial profits not only eases stress levels, but it also helps build your confidence while you are learning forex trading for beginners and finding a trading method and style that works for you.

Unlike stock brokers, forex brokers’ fees are based on spreads (number of pips between the bid and ask). That means they make money on your trading volume (the amount of currency you trade) rather than your trading frequency, so you pay no extra for partial exits and entries. How often you use these will depend greatly on your confidence in a given exit or entry point. When you’re very confident about a trade, you’re more likely to keep the full position open until you hit your planned exit point.

Understanding how stop-loss and trailing-stop works is important, but if you want some help, the MetaTrader platform - Download MT5 - offers 6 types of orders and our trainers can provide you the right guidance. Play around in a ​forex demo account and notice how stop loss and trailing stop can protect and maximize gains.

You can test an automatic position closing by creating an EA Forex in Robo-Advisor 007 (14 Days FREE Trial).

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Categories:  Education