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.
Strategic Methods for Setting Stop Loss Orders
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.
Percentage-based Stop Loss
A stop-loss determined by a percentage-based method is set at a level of a fixed percentage of your total account balance. Or, if you've allocated a specific amount to a trade, the stop-loss could be set at a percentage of that amount. Either way, the risk you're taking is a known percentage of your total capital.
If you have a trading account of $10,000 and can afford to risk only 1% of that on any one trade, your maximum allowable loss is $100. For that trade, your stop loss is at a price level such that, if it were triggered, it would very likely result in a loss of around $100. For the purposes of this example, we are leaving out the other factors that might come into play when determining exactly where to place a stop loss.
When to use: This technique is especially beneficial for novice traders who want a straightforward, reliable method for managing net risk across several trades.
💡Tip: When developing a strategy, always calculate position size based on the percentage of risk you have chosen and the distance between your entry price and stop loss price, so that your actual loss, if it comes to that, aligns with the risk you predetermined.
Effective Methods for Setting Take Profit Orders
Risk-Reward Ratio
To set a take profit based on the risk-reward ratio means to set a profit target that's a specific multiple of the risk taken in the trade. When forex trading in the market, a common target to aim for is a profit that's twice the amount of the potential loss.
If your stop loss is 40 pips from your entry price and you have a 2:1 risk-reward ratio, you would set your take profit 80 pips away in the direction of your anticipated profit.
When to use: This strategy works particularly well in markets that are trending, wherein it encourages you to let trades that are winning extend while it also ensures that the profit potential justifies the risk. When the market is moving in a certain direction, it can seem obvious to cover a winning trade or shorten it.
Strategy tip: Examine past price data and use technical indicators to discover sensible support and resistance levels that can function as profit targets within your desired risk-reward ratio.
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Fixed Take Profit
A take profit that's set at a fixed level is determined before entering the trade and is often based on technical analyses. Traders frequently identify key levels—which could resemble any of several high-profile chart patterns or the types of levels we noted above—as potential profit targets at which they would like to exit a trade.
Say you're going to take a long position on the EUR/USD. You notice there is some strong resistance at 1.2100 and set your fixed take profit just below this level at 1.2095. You think of this arrangement not as a given condition but as a play for hitting a target somewhat under the radar.
When to apply it: This technique is suitable for sideways or for range-bound markets, where the price is expected to fluctuate between well-defined boundaries.
Strategy tip: Make certain that your selected level corresponds with noteworthy technical levels highlighted by comprehensive chart analysis to boost the chances of your target being reached.
Trailing Stop
A trailing stop is an order to sell that adjusts automatically and follows price movements in your favor. For long positions, the trailing stop moves up (that is, it gets closer to the current market price) as the price increases. That's how it locks in profits. For short positions, a trailing stop also locks in profits but only as price decreases.
Envision purchasing GBP/AUD at 1.9000 with a trailing stop set 50 pips away. If the price moves up to 1.9050, then your stop loss automatically goes to the 1.9000 level (right at your entry). If the price continues to move to 1.9100, then your stop adjusts to 1.9050, which guarantees you a 50-pip profit if the market reverses.
When to use: Use trailing stops in strongly trending markets. They allow you to wring out every last bit of profit from a move and also provide an excellent mechanism for staying with a trending market until either the market reverses or you hit your set profit target.
Strategy tip: Set the trailing distance based on the currency pair's volatility and your trading timeframe. Wider trailing stops suit highly volatile pairs or longer-term trades, while tighter distances work better in less volatile conditions or shorter-term strategies.
Adapting to Different Market Conditions
In Trending Markets
When prices in the market are headed in a single sustained direction, these are some good strategies for using stops and profit orders:
• Use a stop that is wide enough to accommodate a typical retracement that does not violate the trend.
• Place the stop beneath a significant support level when you are in an uptrend (or above a significant resistance level when you are in a downtrend).
• Set your profit order at the next resistance level (in an uptrend) or support level (in a downtrend).
• Consider the use of a trailing stop at some point to maximise the profit from what is hopefully a developing trend.
In a clear uptrend in USD/JPY, for example, you would place your stop beneath the most recent swing low (support level) and set your profit target near the next resistance level.
In Sideways or Range-bound Markets
In a range-bound market, Forex trading necessitates an alternative approach to risk management for beginners. Here are several guidelines to contemplate:
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Maintain stop loss orders that are tight but well-placed relative to the market to allow for long or short positions. A stop loss for a long position could be placed just below a market support level, while a stop loss for a short position might be well above a key resistance level.
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Set take profit orders at what seems a reasonable level, given the price action and context of the recent market behaviour. Generally, try to make them at what will yield a decent reward-to-risk ratio.
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Watch the market like a hawk. The signs that the market is ready to break out either up or down could happen at any time.
If EUR/CHF is trading between support at 0.9500 and resistance at 0.9550, a long position near 0.9505 might have a stop loss just below 0.9500 and a take profit just below 0.9550. Be prepared to adjust orders if price breaks decisively above resistance or below support.
In Volatile or News-driven Markets
Especially in light of economic releases or geopolitical events, we must give our undivided attention to the markets. Why?
Because these events push the markets one way or the other—sometimes very dramatically, as we saw just last week when the jobless claims release sent the markets into a tizzy.
Herewith, some tips for trading in such upward-downward susceptible conditions.
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Expand stop loss orders to allow more room against rapid price swings.
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Think about employing stop loss orders during critical news occurrences (some brokers provide this for a fee; it can also be an insurance policy that is worth paying if guaranteed fills are what you need).
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Alter take profit levels and consider using a trailing stop order if a strong trend is present due to volatility.
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Keep yourself updated on forthcoming news events by using economic calendars.
Prior to important declarations such as the US Non-Farm Payrolls, think about expanding your stop loss on impacted currency pairs. This is to accommodate the likely rapid movement we may see in either direction.
Common Mistakes to Avoid
Setting Stop Loss Too Tight
One of the common mistakes is placing stop loss orders too near the entry, especially in erratic markets. When a stop loss is overly tight, even regular market swings can set off the order earlier than one wishes.
On the unstable GBP/USD pairing, putting in a stop loss merely 10 pips from entry could see a trader stopped out by a minor, temporary price swing, even if the price then turns around and moves in the trader's favor.
Answer: Make sure that your stop loss gives enough leeway for market fluctuations that are just a part of natural activity. Using ATR-based stops can help with this, as they adjust to how much any particular currency pair is likely to move. And currency pairs can vary enormously in their volatility.
Failing to Adjust Orders as Trades Progress
Another prevalent error is the failure to adapt stop-loss and take-profit levels in response to changing market conditions or when trades start to generate profit.
For example, suppose you enter a long position and the price moves significantly in your favor. If you then fail to move your stop loss to breakeven or a level that locks in some profit and if the market suddenly reverses, you could watch your profitable position turn into a loss.
The answer: Keep reassessing your levels as the trade unfolds, particularly when the market is trending or volatile. Think about whether to adjust your stops to breakeven or use partial profit-taking to ensure that you don't give back a ton of what you've already made. There's nothing wrong with using a trailing stop for this, especially if you want an automated solution.
Conclusion
Indispensable for forex trade management and trading success, stop loss and take profit orders must be used effectively. Methods for setting these orders vary, and they must be adapted to different market conditions. Even then, they must be used with an understanding that we're controlling risk and securing profits better than in some other way, presumably.
Achieving lasting success requires the disciplined and consistent application of sound risk management forex principles. Ensure you have a solid grasp of the following techniques before you contemplate applying them in a live trading environment. These techniques are best practiced on a demo account first. Consider the following tools and techniques for your risk management enhancement program.
In forex trading, retaining your capital and properly controlling risks often makes a bigger difference than chasing after unusually large profits. If you can grasp these basic principles and tools and work with them effectively, you're a long way toward becoming a successful trader.
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