All profit opportunities in global markets carry a certain amount of risk, and the Forex market is no different in this regard.
While there are many ways to keep risks under control and limit risks, one of the most effective and most widely used are stop-loss orders. Stop-losses play an integral part in any well-round risk management and should be well understood, even before you place your first trade in your trading career.
Underestimating risks and accumulating losses are arguably the number one mistake that new traders make in the markets. Here, we’re going to explain how to keep an eye on your risks and limit losses when everything turns against you using a simple tool – stop-loss orders.
What is a Stop-loss and Why Should You Care?
There is a saying in the trading community that 90% of traders lose 90% of their trading capital within 90 days. While successful trading depends on a variety of factors, this statistic could have been much better if new traders used stop-loss orders in an effective way, as part of a well-designed trading plan.
So what is a stop-loss exactly? A stop-loss is a pending order that automatically exits a trade when the market turns against the position, that is, it sells a long position or buys back a short position. In essence, a stop-loss order becomes a market order once the market reaches a pre-specified price-level, also called the stop-loss level.
This helps traders to avoid unexpected losses in the event of increased volatility or during times when the trader is not in front of his trading platform. Additionally, a stop-loss order combined with a take-profit order can eliminate any further work regarding a trade by simply letting the position to perform.
How do Stop-Loss Orders Work?
In essence, stop-loss orders are buy stop and sell stop orders that get executed when the market reaches a pre-specified level. If you’re long, stop-losses sell your position, and vice-versa.
It’s important to note that a stop-loss order always follows the ask rate when applied to a short position, and the bid rate when applied to a long position. For example, if you’re long EUR/USD at 1.1050/52 and place a stop-loss order at 1.1020, the stop-loss will get triggered only if the bid rate reaches that level.
During times of high market volatility, such as when important market reports get released, imbalances in the market may lead to slippage and the widening of spreads, which in turn might fill your stop-loss order at a significantly different price. In fact, almost 44% of all stop and stop entry orders received negative slippage, according to the slippage statistics of a large broker.
Preferably, a stop-loss order should be placed tighter than the potential profit target in order to maximize a trade’s risk-to-reward ratio and improve profitability in the long run. By taking R/R ratios into consideration, even a mediocre win rate of 50% can return significant profits as the average profits of a winning position will be higher than the average losses of losing positions.