How to use stop loss orders to control risk

Market risk refers to the risk of losing your invested capital due to rapid market movements. When the market moves in the opposite direction of your trade, you will start losing money and the losses will continue to run until you close the position. A stop loss order can help minimize financial losses by placing a limit on the amount you are comfortable losing.

How to use stop loss orders to control risk

Stop loss orders are the first and easiest step in protecting your investment during trading. The more volatile the market, the more crucial a stop loss order becomes. In fact, a stop loss can be the difference between losing 10% of your balance and blowing out your account entirely – especially if you are trading with high leverage.

There’s a small caveat, however. If you place your stop loss too close to your entry price, there’s a big chance that it will get triggered prematurely as the market goes through the motions of finding a new resistance/support level. Therefore, while a stop loss can help protect you from risk, it can also take you out from an otherwise profitable trade. Setting a stop loss too far away from your entry can result in huge losses if the market turns on you as well and as such, you need to find a balance between the potential risk and reward.

 

Trading with a stop loss

When an order is placed on a trading platform like MT4, you are presented with the option to set your stop-loss and take-profit targets along with your market order. When the price of the currency pair or asset you are trading hits the target you specify, the trade will be automatically closed on your behalf and any profit or loss will be realized in your account.

For example, let’s assume you wish to place a buy order on EUR/USD which is currently trading at 1.1115. You believe the EUR will rise in value, but you don’t want to risk losing too much on this order and you place your stop-loss at 1.1100 – 15 pips below the opening price – just in case the USD comes out on top instead.

Now, consider that the pair started rapidly dropping in value – hitting the 1.1100 target in a couple of minutes after you placed your trade. This will result in triggering your stop loss order and automatically closing your trade. You may have lost a few pips in this trade but at least you were protected from further downside risk as the pair continued to depreciate further.

However, a few more minutes go by and the EUR starts climbing again and settles around the range of 1.1150 against the USD. Therefore, if you didn’t set such a tight stop loss, you may have had the chance to realize a healthy profit eventually. That’s why you need to consider how volatile the market is before placing a stop loss and you need to factor in this volatility in your calculations. Sometimes, the added risk exposure may be worth it – in case the market needs to first find strong support before it gains upside momentum.    

 

The benefits and drawbacks

One of the key advantages of using a stop, aside from protecting your account from substantial losses, is that you alleviate the need of having to constantly monitor the charts in order to close your trade in case it goes awry. You just open a position and let it run until it hits your predetermined stop-loss or take-profit targets automatically. The take-profit level can be set in conjunction with a stop-loss order and this guarantees that if the price reaches this point, your trade will be closed while it’s still in profit and before the market starts reeling back to lower prices.

This set and forget approach is very practical as it also removes any hasty and emotional decisions  which cause many traders to close out their trades before they had a chance to turn a profit or when they let losing trades run for extended periods resulting in larger losses.

The one thing traders should note regarding stops is that in fast-moving markets where prices move rapidly and liquidity dries up. This then leads to slippage and stop losses not being triggered on time. When slippage occurs, your order will be filled at the next best available price which may not be as favorable as the one you initially expected.

 

Where to set your stop loss?

A great approach to determine where to place your stop loss is to look at the chart itself. Support and resistance levels are basic indicators that reveal key points where the price will usually bounce or break out from depending on market sentiment.

As the price moves up and down according to supply and demand, most of the time, you will notice that there are levels the price has trouble moving beyond or below and this tends to happen again and again until eventually either the buyers or the sellers will gain dominance. When this happens, the price will usually break through the artificial floor or ceiling with increased momentum.

This is why it’s beneficial to set your stops and take-profit targets close to key support and resistance levels respectively.

Put simply, if you notice that the price of the EUR/USD for example is rallying and it has shown to reject a move below the 1.3000 level (support) even when it has tested that price a couple of time before, placing a stop-loss just below that level makes the most sense. If the price does move past 1.3000, it will surprise the market and most investors will start selling in anticipation of further devaluation.

To reiterate, if you are buying a pair, place your stops below the points where the price tested previously and found strong support. When you are selling a pair, place your stops above the point where the market has shown resistance

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