In online forex trading, avoiding losses is crucial to achieve a profit. But when you’re trading in a highly dynamic market, it’s tricky to keep up with all your different trades – let alone determine the best time to buy or sell. And while it’s certainly ambitious to try raking in obscene amounts of profit by taking advantage of fluctuations, you still need a barricade to protect your bottom line. This means activating a stop-loss on each order. These orders trigger automatic buying or selling options once an asset reaches your desired price, preventing you from buying for too high or selling for too low a price.
If you’re not sure about how to enter stop-loss orders and what the best strategies are, this is a good place to start. We’ll discuss what they are, why they’re necessary, and how you can set them up for greater control of your portfolio.
What Are Stop-Loss Orders?
In trading, stop-loss is a risk-management technique that automatically sells an asset as soon as it reaches a specific price. You can designate this level as a percentage of the existing price or a dollar amount below the existing market price. In the event that the security’s price falls below a certain price level, stop-loss orders are activated to reduce losses. Here’s an example:
Suppose you buy 100 shares of a stock for $1000 and keep your stop-loss order at $900. In the next couple of weeks, the price of the stock falls until the value of your trade is below $900. This triggers your stop order, and you’ll sell your shares for $899.95. Here, we assume that you believed that if the value of your shares fell to $900, they’d fall even further. That’s where your stop-loss order comes in – it protects you from further losses without requiring you to constantly monitor the security’s activity.
Why You Need Stop-Loss
Using stop-loss orders is basic risk management 101 because it lets you preserve invested capital. They do this by fulfilling three purposes:
Avoid Potential Losses
As the market shifts and prices fall, you’re bound to experience losses. Stop-loss orders keep that from happening by setting a specific price level for when to sell. This keeps your invested capital from extensive losses. Remember that avoiding losses is more important than improving profits.
Take Emotional Bias Out of The Equation
Another important reason for setting up stop-loss orders is that they prevent emotional trading. Feelings like fear of missing out and greed can hamper your judgment. This can cause you to buy or sell too quickly or not soon enough. Setting predetermined price levels ensures that you stick to the strategy without being swayed by emotions.
While stop-limit orders are similar to stop-loss orders, they’re not the same. In a stop-limit order, you have a stop price and a limit price. Rather than selling a security for the next available market price, a stop-limit order will only sell it for a predetermined price or higher. Let’s suppose you set a stop price at $14 and a limit order at $12.50. If the security falls below your stop price, the broker will only sell it at the limit price or higher.
Types of Stop-Loss Orders
You can classify stop-loss orders into two categories as follows:
When you set a buy-stop order, it triggers the broker to purchase a security once it reaches a specific price level. You set the stop price at a level above the current market price. You can use this during stock or forex trading, as it allows you to benefit from an uptrend by placing an order in advance. At the same time, it prevents the loss of an uncovered short position.
The opposite of a buy stop is that you enter a sell stop order by placing it at a level below the current market price. So, if the value of the security drops to the stop price, your sell-stop is triggered and the security is sold at the current price. Usually, traders place the sell stop at a lower level than the current market price, and it’s effective for protecting your accumulated profit.
Best Stop-Loss Strategies For Forex Trading
Now that we’ve gone over the definition of stop-loss, an example of what it means, and the different types of stop-loss orders, let’s look at a few of the best strategies you can use for trading in 2024.
Although technical indicators give you information about price action, they can also be used as stop-loss levels. You can set up static stop-loss levels using indicators like ATR, average true range, and Fibonacci retracements.
- ATR shows you price movement over a specific time, i.e., volatility. Depending on how volatile a security or asset is, the ATR can go up or down. There are different ways to use ATR to set stop-loss levels. One way is to set your stop level at the ATR value when you enter the position. However, traders who prefer a more aggressive approach set up multiple stop-loss offers at various ATR levels.
- Another option is to use Fibonacci retracement levels. Traders use this indicator by placing a stop-loss after the next retracement level. If you didn’t know, the most common Fibonacci retracement levels are 23.6, 38.2, 50, 61.8, and 78.6 percent. Let’s say you wanted to enter the market at a 50 percent retracement level. In that case, you’ll place a stop-loss order past the 61.8 percent level.
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Using Multiple Stops
While this strategy isn’t for everyone, some traders may set multiple stops at different levels to protect their position from unexpected reversals or sudden pullbacks. Of course, you can’t avoid losses completely, but it still prevents losses that would’ve occurred otherwise.
A common stop-loss strategy is a percentage-based method in which you set the level according to a percentage drop from the current price. Let’s say you purchase a security for $100 and set a stop-loss at 2 percent below the entry price, making $98 your stop-loss level. Now, if the price of the security falls to $98 or less, this price movement activates the stop-loss, allowing you to exit with a loss of $2.
Typically, the whole point of setting a stop-loss is to prevent losses. However, a trailing stop allows you to gather profits instead of closing your position right away. With a trailing stop, the stop level moves a fixed distance with the price action, all while maintaining the predetermined percentage. This means you lock in profits as your trade moves favorably. A trailing stop will only move the stop-loss level if the price moves in the desired direction.
It’s a useful tactic if you want to let your positive position continue while protecting your investment from reversals. Suppose you take a long position on security at $20 and keep the stop-loss level at $18. If you use a trailing stop and the price goes up, your stop-loss level can be adjusted to $20. So, even if the market pulls back, you’ll still break even.
Support and Resistance-Level
Let’s take a look at setting stop-loss orders based on support and resistance levels. In case you didn’t know, these are areas on a chart where the price previously saw buying or selling pressure. These are usually the prime points for price reversals. It’s why many forex traders are adopting this popular strategy in 2024.
Since most trades have an upward direction, also known as a long position, a stop-loss is placed below the support level. This protects you from the price dropping further. If you have a short position, you can set a stop-loss order just over the resistance level to protect you from the price going up.
With a volatility-based strategy, you set a stop-loss level according to the market’s volatility. This refers to how much the value fluctuates over a specific period of time, and you can calculate it using indicators like ATR or average true range. There are three components of a volatility-based stop-loss: volatility measure, safety multiple, and price anchor.
The first step is to choose how you’ll measure volatility, like standard deviation or average true range. Then, you narrow down a safety multiple, which reflects how aggressive you want to be while setting a stop-loss. For instance, you choose standard deviation to measure volatility and a safety multiple of 3. If the standard deviation of the asset is 7, then the stop-loss distance is 21. Lastly, you select a price anchor; you may say that 215 is the last closing price. Using the anchor price, you can project the stop-loss distance and know where to place the level. In a long position, you’ll subtract the stop-loss from the price anchor and vice versa for a short position.
With the confluence strategy, you implement different indicators or techniques to select a stop-loss level. You can choose from different indicators, including support and resistance levels, trendlines, and Fibonacci retracements. By using multiple techniques and indicators, you have a higher chance of the stop-loss level being implemented. It also reduces the likelihood of your position being stopped because of a false signal.
For example, you use two technical indicators, MACD levels and Bollinger Bands. MACD is short for moving average convergence/divergence. It’s a momentum indicator showing you the relationship between the exponential moving averages of an asset’s price. It compares short and long-term moving averages to give you possible buy/sell signals. Meanwhile, Bollinger Bands assesses price volatility by plotting a central moving average with two standard deviation levels above and below. It’s much better to use two indicators than just one. Otherwise, you risk setting it too tight.
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In addition to the above-mentioned strategies, there are a few things to keep in mind while setting a stop-loss on your trade.
Consider Your Position’s Risk/Reward Ratio
For starters, it’s best to think about the risk/reward ratio of your trades. Experienced traders usually have a thorough understanding of their risk aversion. If you’re just starting out, consider whether or not you still feel nervous despite setting a stop-loss. If you do, it means you’re forcing yourself to give up more than you’re comfortable with. Instead, stick to a lower risk tolerance that aligns with your goals.
Beware of Stop-Loss Hunting
Stop hunting is a strategy employed by large institutional traders with the aim of deliberately triggering smaller traders’ stop-loss orders. It’s a form of market manipulation that’s used to shift prices in their desired direction. The goal is to push other traders to buy or sell more of a specific security. This, in turn, causes a domino effect that drives prices higher or lower. One of the ways to avoid being the target of stop-hunting is to find areas with large numbers of stop-loss orders.
One way to do this is by finding key support and resistance levels. As prices approach these levels, you’ll find numerous orders placed just below or above the area. By determining these levels, you can avoid placing a stop-loss order that puts you at risk of being stop-hunted.
Look Out For Round Numbers
This brings us to the next point: not placing stop-loss orders at round-number prices. If the current value of a stock is at $30, setting a stop-loss order at $29 or $31 seems tempting since the number is easy to remember. But keep in mind that institutional traders may target these levels to trigger a wave of buying or selling. That being said, it never makes sense to set stop-loss levels using ‘mental stops’ or arbitrary numbers. You should select a price level for your stop-loss order based on technical indicators and the likelihood of them being reached.
Stop-loss orders are an important technique for protecting your investment from further losses. There are different types of stop-loss strategies, like percentage-based stops and volatility-based stops, or using indicators like ATR and Fibonacci retracement levels. Similarly, you can use support or resistance levels, a trailing stop, or a combination of different indicators, also known as the confluence strategy. Besides these strategies, remember to use a trusted broker service, avoid round numbers, and consider your risk tolerance before setting stop-loss orders.