What is Stop Loss? 4 Types of Stop Losses, Rules and Mistakes on Stop Loss

What Is Stop Loss in Trading?

A stop loss in forex trading is a type of order used to limit potential losses on a trading position. It’s an instruction to close out a trade at a certain price that is less favorable than the current market price in order to prevent further losses.

For example, if a forex trader buys EUR/USD at 1.2000, they might set a stop loss order at 1.1950. This means that if the price of EUR/USD falls to 1.1950, the trading platform would automatically close the position, limiting the trader’s loss.

Stop loss orders are a key risk management tool in forex trading. They allow traders to specify the maximum amount they are willing to lose on a trade without needing to monitor the market constantly. However, like all trading strategies, they come with risks and should be used as part of a comprehensive trading plan.

Is Stop Order and Stop-Loss Order Same?

Yes, a stop order and a stop-loss order are essentially the same thing. Both terms are commonly used in financial trading to refer to an order placed by an investor or trader to sell an asset (such as forex, stocks, options, or futures) when it reaches a specified price level.

A stop order is like a rule you set when you’re trading things like stocks. It says that if the price of something you own reaches a certain level, you want to either buy or sell it right away.

For example, let’s say you own some FX currency, and you don’t want to lose too much money if the price goes down. You can set a stop order to sell the stock if its price drops below a specific amount. This way, if the price falls and reaches that amount, the stock will be automatically sold, helping you avoid bigger losses.

On the other hand, if you’re betting that the price of something will go up, you can set a stop order to buy it if the price rises above a certain level. This can help you make a purchase at a good time and take advantage of potential gains.

Types of Stop Loss and How to Set Stop Loss in Forex Trading?

A stop order is like a safety net that automatically triggers a buy or sells action when the price reaches a certain point, helping you protect your money or make better trades.

There are four types of stop loss in forex trading,

1. Percentage stop
2. Volatility stop
3. Chart stop
4. Time stop

Setting a Percentage Stop

Setting a percentage stop in forex trading involves determining what percentage of your trading account you are willing to risk on any single trade. Here’s a step-by-step guide on how to do it:

1. Determine Your Risk Tolerance: Risk tolerance refers to the amount of money you’re okay with losing on each trade in your trading account. A general guideline is to not risk more than 1-2% of your total account on any one trade. For instance, if you have $10,000 in your account and you decide to risk 1%, that means you’re okay with losing up to $100 on a single trade. It’s important to be careful with how much you risk to protect your overall account balance.
2. Calculate the Dollar Amount: Once you know how much risk you’re comfortable with as a percentage, you can calculate the actual dollar amount. This is the specific amount of money you’re willing to lose if the trade doesn’t go well. In the previous example, if you’re risking 1% of a $10,000 account, it means you’re okay with losing $100.
3. Determine the Stop Loss Level: Now, you need to determine where to place your stop loss order. This is the price at which you will exit the trade if it goes against you. This should be determined based on the technical analysis of the currency pair you’re trading.
4. Calculate the Number of Lots to Trade: Finally, you need to calculate the number of lots to trade. This is done by dividing the dollar amount you’re willing to lose (the stop loss in dollars) by the stop loss in pips. For example, if you’re willing to lose $100 and your stop loss is 50 pips, you would trade 2 mini lots (0.2 standard lots) because each pip in a mini lot is worth $1.

Setting a Volatility Stop

In simple words, volatility is the amount a market can move in a given period of time.

Having sufficient knowledge of the potential movements of a currency pair helps you set correct stop loss levels and keeps you in a trade on random fluctuations of price.

Let’s suppose you are in a swing trade and you know that EUR/USD has moved around 100 pips a day over the past month. You can get stopped out early on a small intraday move against you by setting your stop to 20 pips.

This is where the benefit of knowing the average volatility comes to the rescue and gives you enough room to stay in the market for long.

Procedure 1: Bollinger Bands

One simple way of measuring volatility is by using the Bollinger Bands.

Bollinger Bands give you the idea of how volatile the market is in a given period of time. If you are doing range trading, it can be very beneficial for you. All you need to do is set your stops beyond the bands.

If price hits this point, it suggests volatility is growing and a breakout could be on the cards.

Procedure 2: Average True Range (ATR)

Another way of finding the average volatility is the Average True Range method.

It is a very common indicator that is available on most trading and charting platforms.

In order to use ATR, you have to input the number of bars, candlesticks, or time to calculate the average range.

Let’s suppose you are looking at the daily chart and you input 10 into the settings. After that, the ATR indicator will calculate the average range for the period over the past 10 days automatically.

Similarly, if you are looking at the hourly chart, input in the settings will give you data on an hourly basis.

This process can be used standalone or with other stop loss techniques as well.

How To Set a Stop Loss Based on Support and Resistance from Charts

After discussing how you can set stop loss using percentages, we now get into the ways that you can do it using what the forex signals and charts tell you. It makes sense that when we are trading the forex markets, we should base the stops we have on what the markets are trying to tell us.

One of the things that we can see on charts is price action and at times, the price cannot seem to break beyond some levels. Other times, when these support and resistance areas are retested, they might have the potential to hold the forex market from breaking through.

Setting stops that are beyond these levels of support and resistance is a sensible idea because, if the market does not tread beyond these areas, it stands to reason that a break of that area will attract more traders who will want to play the break and push the position you take against you.

If these levels break, it means that there are forces beyond your ken that are pushing the market.

How Do You Do It?

So, let us find out the ways in which you can set the tops based on support and resistance:

If you look at a chart and see that the pair is trading above the falling trend line, you will probably see it as a good breakout trade setup and decide to go long.

However, before you enter this trade, there are a few questions your forex education will demand of you to think about:

1. Where do you set the stop?
2. What are the indicators that tell you when the original idea is no longer valid?

It makes sense that you will set the stops below the trend lines and support areas. If the forex market does move into these areas, it means that the trend lines did were not supported by the buyers and the sellers are now in control.

That means the trade idea you had was invalidated and you should accept the loss as you exit the trade.

An Example: Short EUR/USD

Let’s say you look at a chart and you see that the EUR/USD has been trending down. The price has hit the falling trendlines a few times which shows a clear resistance level.

You will be better off placing a short order right at the downtrend line (1.3690)

So, where does the stop loss get set?

At 1.3800.

If you look closely, you will see that it is above the resistance area or falling trendline.

Say we set the profit targets at 1.3530 and 1.3450.

The trade is set in motion, while the trendline holds as price and resistance falls. You have managed to hit the profit target. The second profit target, you did not hit. You missed it by a single pip. However, by that time, you have moved the stop loss to breakeven (that is where you entered the short) and that means you did not lose anything.

This is just one example of how you can use resistance as a guide that points where you place the stop instead of using some static/fixed number.

How to Set A Stop Loss Based on A Time Limit?

In forex trading, a time stop is when a trader chooses to close a trade after a specific amount of time, regardless of whether they’re making a profit or a loss. This strategy is commonly used to reduce the risk of being in the market during uncertain times or to avoid keeping money tied up in a trade that isn’t performing well. If you want to set a time stop, you can decide in advance how long you’re willing to stay in a trade before closing it. This helps you manage your trading activities and make informed decisions based on time rather than just market conditions.

Here’s how you can set a time stop:

1. Determine the Time Frame: Decide how long you’re willing to let a trade run before you exit, regardless of the profit or loss. This could be a few hours, days, or even weeks, depending on your trading strategy.
2. Set a Reminder or Alert: Most trading platforms allow you to set alerts or reminders. Set one for the time you’ve decided to exit the trade.
3. Manual Execution: When the alert goes off, manually close the trade on your trading platform.
4. Automated Execution (If Available): Some advanced trading platforms or algorithmic trading systems allow you to set a time stop that will automatically close the trade at a certain time. If your platform has this feature, you can use it to automate the process.

Remember, a time stop is just one part of a comprehensive trading strategy. It should be used in conjunction with other risk management tools like stop loss orders, take profit orders, and proper position sizing.

Necessary Calculators You Need

To place the stop loss properly, you must use some calculators such as the forex stop loss calculator, trailing stop loss calculator, ATR stop loss calculator, stop loss, and take profit calculator. However, all the forex trading platforms come with these calculators; you just need to know the ways to use them.

4 Big Mistakes Traders Make When Setting Stops

Let’s discuss the four biggest mistakes most traders make when using stop losses. We have greatly discussed and emphasized on using proper risk management, but what you need to understand is that if used incorrectly, it may lead to more losses than profits. And, certainly, you would not want that.

Placing Tight Stops

The most common mistake is placing tight stops that take away your room to breathing. Always place stops with enough room for the price to flow your way.

The ideal thing to do is to remember the pair’s volatility and the fact that it could fluctuate at the point of entry before moving in a particular direction.

Using Position as a Basis for Stops

It is always a bad idea to use position size like “$X or X number of pips” in place of technical analysis.

We have learned that in our previous lessons, haven’t we?

The way market is behaving has nothing to do with using position sizing to calculate the position of your stop.

You are trading in the market and the best approach, in this case, seems like the movement of the market.

What you need to do is decide to place your stops before calculating your position sizes.

Placing Stops Too Wide

Most traders make the mistake of setting stops too far believing that the price will move their way.

However, it takes away the purpose of setting stops.

Setting far stops increases the amount of pip needed to move the trade in your favor.

The recommended way is to place stops closer to entry than profit targets. Obviously, you want better rewards at a lesser risk.

With a better reward to risk ratio, you are more likely to end up with profits more than 50% of the time.

Placing Stops on Support or Resistance Levels

Placing stops on resistance or support levels is also one of the crimes traders commit.

Technical analysis should be the way to determine the position of the stops.

If you’re going long, you can just look for a nearby support level below your entry and set your stop in that area.

In case you are going short, you can look for a support level closer to your entry point and you can set your stop there.

The reason why placing the stop near the support or resistance level is that there is a chance that the direction may turn in your favor.

By placing your stop beyond that area, you will lose certainty that your support or resistance is broken and the trade idea was not correct.

3 Simple Rules to Set Stop Losses

1. Keep Your Emotions on the Side

Before you put your trade on, your stop adjustments should be calculated just like your initial stop loss.

2. Trail Your Stop

Trailing the stop means moving it in the direction of a winning trade. This locks your profits and manages your risk even if you add more units to your position.

3. Never Widen Your Stop

Increasing the stop increases your risk and the amount that you will lose. Your trade is done if your market hits your planned stop. Bear it and move on to the next trade. Each trade is a new opportunity.

Again, never widen your stop.