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In trading and investment, risks are always present. Financial markets experience ups and downs all the time, as they are influenced by numerous factors. Unless participants hedge risks, they may blow their accounts in a flash.
In short, trading stop loss is indispensable. This is particularly true for retail traders. While institutional players have a number of alternative strategies, individuals should set stop loss for every trade.
Why Trading Stop Loss Is Important
Currency markets may get extremely volatile. No instrument is perfectly stable, as the range of potential drivers seems endless. Traders keep track of economic factors, politics, and geopolitics to anticipate the market reaction. From employment to production to diplomacy, there is a lot to monitor. Here are the most basic examples.
- An unexpected political announcement may send a currency tumbling down.
- Surplus of oil causes the dependent currency to plunge.
- Higher interest rates attract foreign capital into the country, so its currency gains value.
- Trade deficit causes currency depreciation, as imports are larger than exports.
Charts on trading platforms allow you to cut through the media noise. However, traders are not clairvoyants: they cannot predict everything. When you open your terminal in the morning, you may see dramatic changes based on some overnight news. In situations like this, stop loss Forex is a lifesaver. A sudden trend reversal may cause substantial losses.
Failure to recognize risk can have devastating consequences. For instance, consider what happened with the Swiss franc in 2005. The National Bank, which had kept the EUR/CHF pair at the 1.20 level for years, abandoned its policy of artificial restrainment.
As the Swiss franc had grown expensive, the market immediately dropped. The ripples were felt across the world: traders who had not protected themselves with stop loss found their accounts deleted. This shows what no stop loss trading may lead to.
Currency pairs may lose dozens of pips while traders are asleep. This is what happens with GBP/JPY quite often – sometimes, it loses 120 pips. This is why stop loss is also known as a disaster stop. It safeguards your funds from unforeseen market movements, as well as the consequences of poor analysis.
How to Use Stop Loss in Forex Trading
In comparison with institutions, retail traders have a limited arsenal of risk management tools. Big players use options to protect their investment against potential fluctuations in the currency market. This is a relatively complicated tactic, and it is unsuitable for the average Forex client.
For individuals, the takeaway is simple: set your stop loss, accept it, and move on. Suppose you limit losses to 0.5% of your account, and the market then collapses. Thanks to the preventative measure, you lose less than your peers who neglected the tool. Hope is not a strategy: it is a surefire way to waste money. Read on to learn how to use stop loss in Forex trading effectively.
Suggested Day Trading Stop Loss Strategy
Traders may set their limits in different ways, depending on their own trading vision. It is possible to use trend lines, trend indicators, or oscillators. The most famous example of the latter is the Relative Strength Index. It pinpoints the most favorable spot for a stop-loss order.
Generally, there are no fixed universal rules for day trading stop-loss strategy as each situation is different. Stop Loss may be static or trailing. In the second case, it must always follow the direction of the target.
Generally, you should aim for levels that exclude huge losses and allow the price to rebound in a favorable direction. A trader makes decisions based on their own risk tolerance level. To some participants, a 40-pip loss is acceptable, while others are only willing to risk 10 pips.
Here is a simple stop-loss Forex example. Imagine that you want to limit losses when buying a certain currency pair – e.g., EUR/USD. If you decide to enter the trade at 1.1500, your Stop Loss Order may be positioned at 1.1485. This way, if the market happens to suddenly move against you, the damage will be limited to 15 pips only.
Never Trade Without It
Trading without a stop loss is reckless, to say the least. Use the feature for every single position. There are simply too many factors that may wipe out your account. Market trends are predictable to a certain extent: traders have to factor in adverse probability.
To put it simply, we may never know for sure when something will happen. On the one hand, you can force your account to neutral if the decisions fail to generate returns. On the other hand, it is possible to make a profit if the market suddenly moves against you after an established trend.
Alternatives to Stop Loss Forex
So, how do options help? Consider the situation when a trader opens a long position on EUR/USD. If the base currency loses value, it could incur a loss. To hedge the investment, they may buy a put option at the same time. This instrument allows them to sell the pair later at a fixed price.
Hence, if the spot market moves against them, they can still recover a share of the money lost. And what if the pair gains value? In this case, the option will expire. This is a basic explanation, as the tick-by-tick strategy is more complex in practice.
Naturally, retail traders may open two opposite trades to limit their losses. The main drawback is that your profit will also be reduced. In any event, either of the trades will bring a loss. However, when the stop loss is in place, potential profit is unlimited.
The Bottom Line
No Forex strategy is guaranteed to be lucrative. Everything relies on your foresight and common sense, as well as market drivers. Do not try to outsmart the market: it is impossible. Success relies on limiting damage and expanding on gains. As losses are inevitable, using trading Stop Loss is vital.
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