In the fast-paced realm of Forex trading, success usually depends not on how much you can earn, but instead on how well you can handle your risk. Of the many instruments at a trader's disposal, stop loss and take profit orders are among the most fundamental when it comes to risk management in forex. For Forex traders just starting out, nailing down these two critical components of risk management could be the difference between enjoying a long, successful trading career and having their account blown up.
Understanding Stop Loss and Take Profit Orders
What is a Stop Loss Order?
A stop loss order acts as your financial safety net, telling your broker to automatically close a position when the market hits a price level you consider too low. This price level, of course, is not too low for the market—the market clearly has no trouble hitting it! But for you, this is your stop loss level. You must also decide on the price at which your trade should become a stop loss trade.
Consider, for instance, taking a long position on EUR/USD at 1.2000, with your broker's firm expecting you to move upwards, which is why you set your stop loss at 1.1950. If the market goes against your expectation and falls all the way to 1.1950, your loss gets capped at 50 pips instead of going on and on forever. If only market moves could be contained with stop losses.
What is a Take Profit Order?
In contrast, a take profit order tells your broker to automatically close a position when the price hits your preset profit target. This secures your gains by ensuring the market moves in your favor to a specific level before you have to close the trade.
Think about purchasing GBP/JPY at 160.00 and forecasting that the price will ascend to 160.80. If you place a take profit order at this level, you're telling your broker to cash you out when the price hits 160.80. This is a good plan because it nets you an 80-pip profit 'safely,' without putting you at market risk during the time your position is open.
Why Stop Loss and Take Profit Orders Are Essential
Risk Control
Fundamental forex risk control techniques are embodied by stop loss and take profit orders. These mandates permit the precise definition of risk on a per-trade basis and, consequently, the unfettered entry into the market with a clear mind. No single trade can devastate your account, even in extreme volatile conditions, if you set a stop loss at the appropriate level.
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Emotional Discipline
Successful trading demands effective trade management in forex, removing the emotional side of trading from the equation. Fear and greed are emotions that many traders experience. You can combat the influence of these emotions in trading by first understanding them and then using methods to nullify or minimize their impact on your trading decisions. Two common methods to achieve this are implementing stop loss and take profit orders. By using these tools, you can take the forex market by the horns and drive your trades to success.
A lot of traders have trouble with two specific aspects of trading. They either close out winning trades too early because they are afraid and don’t trust their trading method, or they hold trades that are obviously losing positions in the futile hope that they will make a comeback.
Let me tell you, stop loss and take profit levels that are predefined and that you stick to can and will save your trading account.
Capital Protection
These orders are very important for protecting your trading capital. Stop losses do not allow small losses to grow into big drawdowns. Take profit orders, secure your gains and prevent them from becoming lost capital due to unexpected market behaviour.
Fixed Stop Loss
With a fixed stop loss, you simply set an exit point at a predetermined price level that doesn't change during the trade. It can be thought of as a stop loss that you would use at a specific number of pips from your entry price (for example, a certain horizontal line in your chart).
It's something you plan for ahead of time, and really, it's mandatory to do so if you want to remain a disciplined trader.
For instance, if you were to purchase USD/CAD at 1.3500, you might designate a stop loss at 1.3470, endangering only 30 pips in the trade. This stop loss would hold firm in the face of any market turmoil.
When to use: Fixed stop losses work best in markets with forecastable volatility, or when you've pinpointed an unmistakable technical level that would call into question your trading thesis.
Strategy tip: For long positions, set your fixed stop loss below the major support levels; for short positions, set the stop loss above the major resistance levels. That way, you will avoid getting stopped out because of minor movements in price.
Dynamic Stop Loss (ATR-based)
An adjustable stop loss responds to alterations in market volatility. One common method employs the Average True Range (ATR) indicator. It measures the average price fluctuation of a currency pair over a set amount of time.
For example, if you were to enter a buy trade on EUR/GBP with a 14-day ATR of 40 pips, you would set your dynamic stop loss at twice the ATR (80 pips) below your entry price. If market volatility were to increase and the ATR rose to 50 pips, your stop loss would automatically adjust to 100 pips below entry.
Use dynamic stop losses when trading in high-volatility markets or around news events, because they are better at handling larger and more erratic price movements.
Tip on the Strategy: Use a multiplier of the ATR (like 1.5x or 2x) for setting stop-loss orders, considering your risk tolerance and the specific volatility character of the currency pair you're trading.
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