Stop losses are a key part of Forex trading and indeed any kind of trading, but they’re sometimes a contested topic. There’s a bit of a debate on whether you should use a stop loss or not, and do professional traders use stop losses or not.
While I can’t speak for all professional traders, I’m going to explain what stop losses are, what their advantages and disadvantages are, and why you as an individual trader MUST use them.
What is Stop-Loss Order?
A stop loss is an order you place against the direction of your trade. The stop loss is designed to prevent you from losing more money than you planned if there is a negative market event.
The order is placed with your broker and if the market goes against you and reaches your stop loss level, the order is triggered and your position is closed.
For example, let’s say that your analysis tells you that the EUR/JPY pair is going to move up. You place a buy trade and you put your stop loss 20 pips below your entry according to your analysis.
If the trade goes against you, the most that you will lose is 20 pips. Essentially, the stop loss helps make the losing position a very defined outcome: the most you can lose is 20 pips in this case, not more.
A properly priced stop loss system can make sure that your equity curve remains in the green!
What is a hard stop and a soft stop?
Many professional traders use a soft stop instead of a hard stop.
Essentially, a hard stop is where your stop order is already on the market, and it will be executed whether you’re at the charts or not.
A soft stop is also a mental stop loss, which is a zone that you’ve identified on the charts that will invalidate your initial trade idea.
If the currency pair’s price hits that zone, your trade is invalidated, and you manually close the trade.
In my experience, using a mental (soft) stop is a bad idea for professional traders, and a terrible idea for beginner traders.
Why a mental stop loss is a bad idea
Mental stop losses might seem like a good idea in practice: after all, sometimes it’s difficult to gauge where exactly price is going to go before moving in your direction.
Also, how many times have you been stopped out only to have the trade start going in your direction!
The last reason is also precisely why you shouldn’t use a mental stop loss.
When you’re actually in a losing trade, your better judgment goes out of the window and you tend to let your losers run and cut your winners short.
That’s because losing trades leave you in the hope of recovering some of your losses, and winning trades trigger fear of losing your gains.
So if you’re in a losing trade and price approaches your stop loss zone, you will find it very difficult to trigger the stop loss. Instead, you’ll be very tempted to let the trade run.
Even professional tradesr experience greed and fear. If newer traders try trading without a stop loss, it’s a recipe to blow your whole trading account.
Do stop loss orders always work?
There are a few situations where stop loss orders may not get triggered. If there’s a brief but violent downturn due to some news event or black swan event, the price of the currency pair may jump significantly from one range to another, and many stop losses will not get triggered at the set price.
Instead, they’ll get triggered at whatever price the market reaches.
Here’s an example:
Suppose you place a buy order on the EUR/USD at 1.1305 and place a stop loss at 1.1275, 30 pips away.
That day the Non-Farm Payrolls report comes out and it’s a bombshell report, so price gaps 50 pips directly to 1.1255. Here, it’s possible that your order will trigger at 1.1255 instead of your original stop loss at 1.1355.
However, bcause of the way Forex brokers use stop losses, they will almost always trigger if the price crosses your threshold.
Advantages of Using a Stop Loss Order
The most important reason that you must use a stop loss is because it limits the extent that you can lose money.
Without a stop loss, you stand to lose your entire trading account if you are not careful.
Using a stop loss is a very important way of protecting ones self in the market.
Also, just because you got stopped out of a trade doesn’t mean you can’t re-establish exposure by getting back into the market if it continues going your way.
Stop loss orders are also a way to lock in profits
One of the key benefits of stop losses is that they can help secure profits in your open positions, helping you maintaining exposure while eliminating risk.
Many traders use something called a trailing stop where they’ll move the stop loss below the low of the previous candle in an uptrend, or above the high of the previous candle in a downtrend.
As the market moves and every new candle prints, they keep moving their stop loss until they’re finally “stopped out” at a profit.
Another way to use stop losses is by moving stops to your entry price to eliminate all risk on a position.
This is very useful in a heated market where price can go in any direction. Here, you’re protecting exposure by removing all risk and essentially getting a “free” trade.
Disadvantages of Using a Stop Loss Order
It’s unfair to say that stop loss orders themselves have any disadvantages because they are an essential part of all trading strategies. However, the way traders place their stop losses can be an issue sometimes.
Stop losses commonly cluster around certain key levels where lots of traders have entered a particular position.
This is simply due to the fact that many people are seeing the same thing happen on the charts and they’ll all place orders in that zone.
Market makers understand this, and they’ll often cause the price to wick against the intended direction, triggering all those stop losses before pushing the price back where it was supposed to go.
There are two ways of getting around this:
- Place your stop loss a little further than you typically would
- Wait for confirmation of the move and get in one candle late
Hedging vs Stop Losses
One popular argument against using stop losses is to hedge your positions.
Hedging is a strategy where you take two opposite positions on either the same asset or two different assets.
The idea is that once you’ve hedged your position, you no longer need a stop loss, because one trade will go into a loss and the other will go into a win.
Here’s the problem with this and hedging strategies in general:
AUD/USD and NZD/USD are two currency pairs that move fairly consistently with one another, meaning they are highly correlated.
Let’s say you open a buy position on the AUD/USD and a sell position on the NZD/USD, hedging your main AUD/USD position.
Once the market has decided which direction it is going in, you close one position for a loss of 20 pips and let the other one run.
The moment you close one position, you have a realized loss of 20 pips and unrealized profit of 20 pips. The market can just as easily reverse on you and take away your unrealized profit, leaving you with a net loss of 20 pips, or worse, even more.
Another popular hedging strategy is to place opposite orders on two correlated pairs, and favor the currency that seems to be stronger.
To go back to our AUD/USD and NZD/USD example, you’d look at the AUD/NZD pair to see which of the two currencies is stronger and base your trade upon that.
The main caveat here is that your analysis of the AUD/NZD still has to be correct for your trade to pan out!
Related: Do trendlines work?
Conclusion: Is a Stop Loss necessary in trading?
Stop losses are a key part of any trader’s arsenal before they get any market exposure. There is absolutely no way to know how the markets will behave, and if the market moves violently against you, you must protect yourself.
Stop losses help take the fear and greed out of losing trades. They keep losses small and trailing stops create a sense of security by assuring some profit.