The most common phrase you will see when learning how to trade forex is:
“All trading involves risk of loss.”
What this phrase means, is whenever you place a trade, regardless of whether it’s a buy trade or sell trade, there’s a chance you will lose money.
Because it’s possible to lose money trading, it’s really important to correctly manage the money you put at risk, to make sure you don’t lose a large amount.
The simplest tool a trader has for managing risk is the stop loss order.
A stop loss order lets you determine how much money can be lost on a trade. It does this by allowing you to decide how far the price can move against the trade before it is closed.
If the market reaches the price you have placed your stop loss, the trade will be closed automatically, (whether you are monitoring it or not) and you will lose a certain amount of money. How much you lose is determined by the size of the trade you placed, and the distance the stop loss is away from the price the trade was executed at.
The fact that the stop loss causes the trade to be closed automatically is really helpful, because it save traders from getting caught in situations where they refuse to exit a trade in the hope that it will eventually turn around – which it of course almost never does.
The stop loss is vital to trading forex successfully.
In today’s article, I’m going to talk more about why it’s necessary to always use a stop loss, and also explain how a stop loss allows you to remain emotionally distant from your trades.
Emotional Management
A large part of using a stop loss comes down to emotional management, or limiting the amount of control your emotions have over your trading decisions.
Trading is always an emotional rollercoaster, and it’s easy to lose patience because of fear, or risk too much money because of anger. Making emotional decisions is the most dangerous thing you can do as a trader, because trading on feelings without some kind of plan in place is no different to gambling at a casino.
Without a trading plan, you simply make a prediction as to whether the price of bitcoin is going to rise or fall, and then buckle in for the emotional roller coaster that follows. This is why using a stop loss is so important, and why one needs to be placed with every trade.
A stop loss is the most basic tool you have to separate your feelings from your trading plan. It insures that when you make a wrong prediction, you will not lose more money than you choose to risk.
Additionally, it also provides you with a framework for which you can build a trading plan.
For example, if you are using a strategy in which you place a stop loss that lets you risk 2% of your account on each trade, but aim to make 6% profit, you only have to be successful on 3 out of every 10 trades to make a 4% overall profit.
When you look at your trading from this longer-term perspective, each individual trade that “loses”, or hits the stop loss, just becomes part of the larger plan, and you can continue to make money without your brain hitting the panic switch, as you know that you don’t have to make money on every trade to be successful.
The example I gave above can be a useful guideline for risk management. There is one problem with it, however, which is that it is an example of a “hard stop loss”. A hard stop loss is a stop loss that is always set based upon a fixed set of criteria.
If a trader wanted use a stop loss to risk 2% of their account on every trade, that would be an example of a hard stop loss, because the only way they can risk 2% is by placing their stop loss the same distance away from their entry every time they place a trade.
Simply using a hard stop loss is not an issue. The issues arise when a trader using a hard stop doesn’t take into account many of the other factors at play in the market, such as the time frame being traded when placing the hard stop loss.
If the trader in our example trades on the daily time frame and wants to only risk 2% of their account balance on each trade, (lets just assume that risking 2% equates to placing the stop loss 40 points away from the entry price), there is a really good chance their stop loss order is going to get triggered, because a 100 point move is very small on the daily time frame, meaning it’s easy for the price to fluctuate and hit a stop loss placed 40 points away.
The only reason the stop loss has a high chance of being hit is because the trader has not taken the information on the daily chart into account when placing the stop. In order to effectively set a fixed stop-loss you have to take all market information into account. All market information means the ADR (average daily range) of the time frame being traded, the upcoming news announcements being released and the amount of Margin currently in use.
If this information isn’t considered when placing a fixed stop loss, you could end up with a situation like the one seen above, where it’s really easy for the the stop loss to be triggered by the price fluctuating up and down.
Summary
Hopefully you can now see why it’s so important to have a stop loss placed with every trade. If you have any questions about using stop losses, please leave them in the comment section below, or contact me using the contact page.
