Risk Management Strategies: A Closer Look at Stop Losses and Trailing Stops
A key part of becoming a confident foreign exchange trader is familiarising yourself with each of the different forex order types offered by brokers.
Indeed, knowing which order is most appropriate for the task (i.e. asset and place in time) at hand is one of the most straightforward ways of increasing your chances of a profitable trade.
Two trade types in particular — stop losses and trailing stops — are specifically designed to help users manage and mitigate risk when participating on the market, and so should form part of any discerning speculator.
Let’s have a look at both quickly, and examine how combining the two can alleviate take some of the emotional burden from your trading:
Stop Losses: A Quick Refresher
A common tool used by investors looking to limit their potential losses in the event of unwanted market reversals, ‘stop loss’ orders automatically close out the position if and when the value of the asset hits a user-specified lower threshold.
These orders can be implemented on both long or short orders (when they’re referred to as ‘sell stop’ and ‘buy stop’ orders, respectively) — for example, if you’re shorting EUR/USD and enter the market at 1.1800, you could set your stop loss at 1.1700 to ensure that you would only ever stand to lose 100 pips maximum before the platform pulled you out of the trade, saving you from further losses.
Many traders set their stop loss threshold using a percentage of the original opening value that they deem to be the maximum acceptable risk for that particular trade. This exact figure is up to the individual to decide depending on their level of experience, trading volume and the size of their account. As an illustration, in the above hypothetical, a 10% maximum acceptable risk would mean you set your stop loss at 1.062.
Stop losses give you the freedom to go about your business without being glued to your trading chart screen for fear of losing money; you can simply tell the software the minimum price at which you’re comfortable maintaining the position and go about your day.
Further reading: https://www.investopedia.com/articles/stocks/09/use-stop-loss.asp
What are Trailing Stop Orders?
‘Trailing stops’ are similar to regular stop losses in that they’re designed to close out your position if the market moves against you by a pre-determined amount; however, the main difference is that the lower trade-exit threshold isn’t a fixed numerical figure.
Instead, with trailing stop orders the limit (known as the ‘trailing step’) moves with the market, being set a user-specified distance away from the current market value, usually given as a percentage or certain amount of pips. This means that if the value of the asset you’re trading increases, the trailing step will also shift upwards whilst maintaining the set interval.
On the other hand, if your instrument falls in value, the original stop limit will remain in place until such a time that it is triggered, closing out your position as originally planned.
Using this type of order enables you to ‘lock in’ any profits, as your positions will only ever be closed at your original trailing step point — which you will have decided yourself as an acceptable level of risk — or at a new, higher threshold if the market appreciates whilst your position has been open.
Further reading: https://www.thebalance.com/trailing-stop-1031394
Combining Trailing Stops and Stop Losses
Some astute traders favour incorporating both types of order into their positions in order to provide both an absolute floor for their potential losses, whilst safeguarding potential profits in a volatile arena.
When taking this approach, investors should give particular thought to their risk appetite in both these senses; for example, you could set your stop loss at 5% below your asset’s current market price, with the trailing stop set at 7%.
In an appreciating market, the trailing stop would soon overtake the stop loss, rendering it irrelevant — with your new floor instead being the trailing stop’s 7% distance behind the increased price. This method takes some of the emotional pressure off your trade (as you’re insulated from any catastrophic reversals) and enables you to focus more on objective statistics and trends.
For this strategy to work, however, you need to ensure that you leave enough room with your stops to accommodate the normal price fluctuations, ensuring that you only catch true market pullbacks whilst never risking more margin than you’re comfortable with — and the only way to get this balance right consistently is to know your market inside and out!
Further reading: https://mytradingskills.com/what-are-trailing-stops
Are There any Downsides to Using Stops?
Whilst stops can undoubtedly act as a financial life raft for even the most experienced trader, it’s nonetheless important to recognise that stop loss orders aren’t able to prevent losses entirely (no such wizardry exists, unfortunately!) — they can only protect you from the worst effects.
Additionally, because your order is always automatically closed when your pre-determined threshold is crossed, it means you won’t benefit from any correction back to profitability as you’ll already have been pulled out of the market by then!
This is why It’s always worth doing research on your chosen instrument before you put any money into a trade; for instance, if an asset is known to be on the more volatile side (i.e. GBP cross pairs) and regularly fluctuate noticeably in value over a short period, then a 5% stop loss wouldn’t be appropriate and will inevitably cap your ability to benefit from the natural movements of the market.
Adding to this is the consideration that, at particularly volatile periods, there could be slippage, unfortunately leading you to lose a greater proportion of your margin as the value drops further from the then-market price in-between the close-out action and its execution.
Brokers also tend to charge different rates for different order types, so it’s vital for you to be aware of how much you’re actually paying to participate in the market — and, as ever, always double check that your stop-loss order has gone through properly as soon as you’re able!
Further reading: https://money.usnews.com/money/blogs/the-smarter-mutual-fund-investor/articles/2017-06-01/the-pros-and-cons-of-implementing-a-stop-loss
Use at your own risk disclaimer
The content contained herein does not construe any form of advice and the user must not take this as such. We do not accept any liability for the direct or indirect usage of the content held in this article. We strongly advise that you obtain independent financial, legal and tax advice before proceeding with any currency or spot metals trades.
