Let’s face it! Forex trading is one of the riskiest types of trading out there. One of the reasons behind this is the potential risk Forex traders are capable of taking. Forex traders can borrow many times more money than they put up in any trade thanks to the high leverage Forex brokers are willing to offer. As a result, it’s very easy for Forex traders to loss majority (and in some cases, their entire investment) when the market goes against them.
You can however control the risk you take by using one special tool known as stop loss. As the name suggests, a stop loss is a mechanism for stopping losses. A stop loss is simply a predetermined point of closing a losing trade. A stop loss will cut your losses. In ever forex trade you open as a forex trader, there is a 50% chance that the trade might go against you. This is before you consider forex strategies for improving your odds of winning.
Of course the risk of losing in Forex can be reduced with experience i.e. an experienced trader is less likely to lose money compared to a novice trader. It is however important to note that there is no sure way of telling which way the market can go since price movements in the Forex market are affected by very many factors. This is precisely why it’s crucial to set a stop loss or simply, determine the amount of risk you are willing to take with each trade.
Types of stop losses
There are four main types of stop losses. These include; percentage, volatility, chart and time stop losses. Below is a brief discussion of each of these types to help you understand more about stop losses:
1. Percentage stop: As the name suggests, this type of stop loss is percentage-based i.e. set depending on the fraction of money you are willing to risk on a trade say, 2% of your account. Different traders have different risk appetites so it solely depends on a trader to determine the percentage of money they are willing to risk per trade. It is however important to prudent i.e. don’t risk more than 5% of your money on a single trade.
2. Volatility stop: As the name suggests, this type of stop loss is volatility-based. Traders set volatility stops based on how volatile a certain currency pair is in a given time. If for instance, the EUR/USD pair fluctuates 50 pips a day, you can set a stop loss outside that range or depending on your risk appetite.
3. Chart stop: This type of stop loss is based on resistance and support points in Forex charts. Chart stops are placed on or around resistance and support points since such points usually result in price reversals.
4. Time stop: Time stop are based on time limits i.e. a predetermined time in a given trade. Time stops can be set to hit after hours, days etc. Time stops are usually used to exit trades when a trade isn’t going anywhere.
Top benefits of setting a stop loss
A stop loss has a number of benefits. The main benefits include:
1. Cuts losses: A stop loss helps a trader exit a losing trade. This is always a good thing because it saves capital. If the market goes against a trader, they obviously got it wrong predicting the market so cutting losses is the best move instead of hoping the market will reverse.
2. Reduces anxiety: A stop loss also gives a trader peace of mind since the market can go anyway. When you set a stop loss, you don’t have to worry which way the market will go since you only lose what you have decided to lose if your predictions are wrong.
3. Allows you to take on other opportunities: A stop loss also allows you to move on and take on other trading opportunities you wouldn’t otherwise take if you let losses run uncontrollably.