The stop loss is a trading order placed in the broker to sell or buy a currency pair (or any other asset in a financial market) conditioned on the price reaching a certain value. It is mainly used to close an open transaction in case the price direction turns against it, hence its name. For example, if we have a buy position in the EUR/USD and put a stop loss at 50 pips below the entry price, our possible losses in case the price falls will be limited to 50 points (see how to calculate the value of a pip).
What is a stop loss and how does it work?
A stop loss order is a pending stop type order. That is, an order placed at a different price than the current price and that will be executed only if the market reaches that price or exceeds it:
- A stop buy order is placed at a price higher than the current market price and will be executed if the market rises and reaches this price or a higher price. A stop buy order acts as a stop loss when the position we have open in the market is a short position.
- A stop sell order is placed at a lower price than the market price and will be executed if the market goes down to this price or at a lower price. A stop sell order acts as a stop loss when our market position is a long position.
Imagine that you open a buy position in the currency pair EUR/USD of 1 standard lot at 1.2540 with a stop loss at 1.2500. What you have actually done in this trade has been to buy and at the same time put a stop sell order at 1.2500 so that if the price falls to 1.2500 or less, 1 lot will be sold in EUR/USD, the same volume that you had previously bought, and the position will be closed.
On some trading platforms, such as Metatrader, the stop loss can be placed directly when a position is opened and each stop loss is associated with a specific transaction independently. For example, you can have a buy transaction in EUR/USD at 1.2580 with stop loss at 1.2530, another buy position in EUR/USD at 1.2530 with stop loss at 1.2500, a sell position in EUR/USD at 1.2560 with stop loss at 1.2600 and other similar transactions in other currency pairs. If a certain stop loss is executed, the position to which it is associated will be closed without affecting the rest of the transactions.
In other platforms, as in most ECN trading platforms, which operate by net position in the market, there is no stop loss associated with any particular trade because, in reality, there are no independent transactions but a market position determined by the aggregation of all open trades in the same instrument. For example, if you buy 1 lot in EUR/USD at 1.2500 and then buy 1 lot at 1.2600, you will have a net buy position of 2 lots in 1.2550; in this case, a stop loss would be any sell stop order at a lower price. For example, a sell order in 1.2450 for 2 lots that, if executed, would leave your net market position at zero (all your transactions closed). If this sell transaction were of 1 lot and is executed, your net position would remain as a buy position of 1 lot. In fact, in these platforms, it is not possible to have buy and sell positions on the same instrument independently as they are added in the net position.
Like any other type of stop order, the stop loss is transformed into a market order once the price has been reached, so the execution price is not insured and may suffer slippage. Take profit orders could be seen as complementary. Both the stop loss and the take profit are orders contrary to our position differing in that the take profit is a limit type order. For example, if you have a buy position, the stop loss is actually a sell order at a lower price (a stop order) while the take profit is a sell order at a higher price (a limit order).
How to place a stop loss order?
If our trading platform allows to place a stop loss associated with each trade independently, we can put the stop loss directly when we place the entry order. For example, this is what stop loss orders look like in Metatrader:
In trading platforms where positions are handled by net position, stop losses must be introduced, usually, once a transaction is open in the market. That is, first you open the position you want and once it has been accepted you must place a counter stop order. For example, you send a buy order and once it has been accepted and executed you send a stop sell order at a lower price to act as a stop loss.
Stop losses can be modified once they have been sent to the broker. Although there are exceptions and some brokers do not allow any modification and the solution involves canceling the stop loss orders and resubmitting them with the desired parameters.
Advantages and disadvantages of stop loss
The main advantage of stop loss orders is that you don’t have to constantly monitor your positions. Traders can have the confidence of moving away from the monitor knowing that their positions and money will be protected if the market changes its direction. In addition, pending orders are in the broker, not on your PC, so you can even turn off your trading platform. This advantage is especially important for swing trading or in periods where the trader cannot monitor the market 100% of the time.
And the main disadvantage is that the stop order could be activated and executed in a short-term price fluctuation without representing a real change in its direction. In other words, the price could reach and activate the stop order and then resume the predicted initial direction. The key is to put a stop loss that allows these fluctuations taking into account various factors. For example, if a given currency pair had an average daily fluctuation of 100 pips in the last month, putting a stop loss of 50 pips may not be a good idea. Although the suitability will depend on many other factors, fundamentally the strategy and trading style of each trader. In general, the stop loss should be placed at that point where the fluctuation puts in doubt the forecast that had made you open the original position.
Another aspect that we cannot forget is, as I mentioned before, that a stop loss becomes a market order once the price indicated in the order has been reached (or exceeded). When it becomes a market order, the price at which the stop loss is finally executed may be different from the indicated price. This particularity, in general, is not noticeable or is very little noticed but it can become a real problem in periods of high volatility or lack of liquidity.
Despite these disadvantages, we cannot forget that a stop loss, first and foremost, will protect our money and limit the risk of our transactions, so that we can protect ourselves when things go wrong. In reality, spreads and/or commissions are paid as in any other trade but the broker will charge these costs only if the order becomes executed. From my point of view, the stop loss is useless only if you are a buy and hold investor. But don’t be confused, using stop loss orders is not going to make you earn money in Forex or in the stock market.
The stop loss also serves to protect earnings
Stop losses also serve to protect the profits in the winning trades. It is an advantage that multiplies by one thousand the utility of the stop loss as a trading tool. We cannot get carried away by the name and think that it only serves to prevent losses, think well about how it works and you will see what I say.
Initially, the stop loss must be placed below the opening price of a trade, that is, on the negative zone, and will be used to cut losses. But once our position has accumulated a good amount of pips we can move the stop loss and place it above the entry price, but below the current market price, so that we can let the trade continue. In this way, we protect part of the benefit while allowing the position to continue adding pips if the price continues in the right direction.
Example: you open a buy position in USD/CHF at 1.0500 with a stop loss at 1.0000. In case the price falls and reaches your stop loss you would lose 50 pips. Imagine the price goes up and reaches 1.1500; You say, WOW, I have 100 pips of profit. According to your analysis, you think that the currency pair can still go up, so you don’t want to close yet. But you also don’t want your position to move from the profit zone to the loss zone. You can move the stop loss, for example, to 1.1000, thus ensuring 50 pips of profit while allowing the trade to continue to develop according to your forecast. In this sense, it is possible to implement what is known as trailing stop that consists in moving the stop loss as the trade progresses, either at a distance calculated as a percentage, at a fixed distance of pips or as indicated by an indicator such as the Parabolic SAR.
Should I really use stop loss orders?
Most analysts recommend the use of stop loss, especially for newbies or those who invest in financial markets without professional training and education. But not everyone recommends its use.
Those who do not recommend using stop loss are mainly based on two statements:
- The use of stop loss can limits earnings due to market fluctuations that may close a position early. I have even seen a study that concluded that the average profit was higher without the use of stop loss. But this study, from 2003, was carried out in a period in which everything went up and with a full economic bubble, so you have to look at it with caution.
- Some market makers brokers cause price spikes that do not occur in the real market or for all the customers of the broker that is hunting the stop loss. This is the practice known as stop hunting. I can only tell you that if you are worried that your broker is practicing stop hunting, change to another broker immediately because it is an inadmissible practice. In addition, save screenshots with the price spikes that have hunted your stop and report it to the competent authority.
