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By FXCompass — Saturday, 20 March 2010

Stop loss orders are one of most fundamental risk management techniques used by forex traders. Ideally, every trading system should include the use of a stop loss on every trade, if only to protect your account from unforeseen events and prevent a margin call.

What are stop loss orders?

A stop loss is a type of order which will automatically close a trade at a set level in order to prevent further losses. If a buy order has been placed, then the stop loss level is set at a price that is lower than the buying price. On the other hand, if a sell order was triggered, then the stop loss will be placed above the selling price.

For instance, say you just bought the EUR/USD at 1.4000 because you expect the euro to appreciate and reach 1.4100 (+100 pips) in the short term. You want to protect yourself by placing a stop loss below 1.4000, say 1.3980, so that if the price does not go your way the trading platform can automatically close the order to prevent you from losing more than 20 pips.

Stop loss orders not only allow you step away from your computer without worrying about your trade, but they also have a psychological effect in the sense that they are much more effective in forcing you to limit your losses than closing your trades manually. This is why using them is so crucial.

How to use them?

The basic idea behind setting a proper stop loss is simple: set the stop loss at the level where your trade will be invalidated. Once you have made the decision to enter a trade, ask yourself were the price would have to go for you to admit that you were wrong — that is where you need to place it.

Depending on which pattern you trade, this is usually right below or above the last inflection point or candle.

Usually, the larger the time frame, the larger will be your stop loss, so you have to make sure that you leave enough room for the price to “breath”. It is a good idea to look at past price action to learn about the typical range for a given currency. For that, you can take a look at the ATR (Average True Range) indicator which gives you the average range of a currency for a certain time frame. Some traders design their trading systems by setting their stop loss levels as multiples of the ATR, but this is more common in automated trading systems.

Finally, do not forget to take into account the spread (difference between the bid and ask prices). If you bought a currency, the stop loss will be triggered at the bid price; if you sold a currency, the stop loss is triggered at the ask price.

Stop loss and VAR (value at risk)

If you decide to use a stop loss then you can control exactly the maximum amount of money that you can lose for every trade — this is called the value at risk (VAR).

To calculate your VAR, simply multiply the stop loss with your pip value. For example, let us go back to our first EUR/USD trade, where we set a 20 pips stop loss (buy at 1.4000, S/L at 1.3980). It you trade one lot, then every pip is worth 10$. Hence, $10 X 20 = $200, this is your VAR.

To properly manage your risk, it is recommended that your VAR does not exceed 2% of your balance. For a $200 VAR, we need a balance of at least $10,000. A typical mistake is to always use the same position size no matter what the stop loss is. The recommended approach is to set the stop loss level then calculate the position size.

Further uses

Stop loss orders can also be used to secure gains or ensure break-even trades. A good practice is to move the stop loss to break even shortly after the price moves in your favour. You can also use trailing stops which automatically move with the price. However you have to be careful as many brokers require the trading platform to be open for trailing stops to trigger.