Traders Blog

Help! Stop my loss!
03/09/2018

One of the first morsels of wisdom usually heard by new forex traders runs like ‘never trade without a stop loss’.

This is certainly good advice because stop losses allow you to cut your losses short fairly easily. They also prevent emotional decisions or temptations to tell yourself ‘let’s just keep it running a few more pips, maybe it’ll bounce’.

If you’ve gained a wee bit of experience trading though beyond the very basics, you’ll understand that stop losses are just one element within a risk management strategy. It’s not a disaster in itself to trade without a stop: in fact, it’s completely possible to open orders without setting stops… but you still need to have a way of stopping losses.

What is a stop and how do I use it?

Stop loss as a function in MT4 is designed mainly to limit your losses and remove the need for you to do this manually by closing orders. It works by closing an order automatically once price reaches a pre-set level in the wrong direction.

Nobody will ever know with complete accuracy which way price will move, so every trader needs some way of cutting losses. The problem with stop loss though is that traders often don’t know where to set it.

Conventional wisdom tells you to set your stop somewhere above or below whatever made you enter a trade with enough room for price to move:

How to use a stop loss

Here, for example, the trader might notice this upward trend on the four-hour chart of cable and want to buy, setting a stop somewhere below the blue trendline they’ve drawn.

So far, so good, but how far below is ‘somewhere below’? This is a tough question and probably the main problem for the trader in this situation.

Many traders might say that the green zone is a good bounce, so the stop should be placed below that, but not too close. Others might argue that the yellow area would be better and that the trader can place their stop fairly close to this.

Either way, if price moved back into that area, it would be clear that the upward trend on H4 would have ended, so the reason for the trade would have disappeared.

What are my alternatives?

Just as there’s more than one way to skin a cat, you can stop losses without using a stop loss order. Let’s consider what the trader sees on the daily chart of cable that day:

Pending order instead of stop loss

It’s a completely different picture from the four-hour chart. If you needed a 50-pip stop to buy on H4, you could think about setting a pending order in the opposite direction instead of a conventional stop loss.

Entering a buying trade at around 1.29200, you could also set a pending sell order at 1.29250 – this way you’d have the same effect of a 50-pip stop loss because your loss is still limited to 50 pips.

What’s also worth remembering is the swap and carry. If this were the other way around – say USD-JPY instead of cable – and you set a pending order rather than a stop loss, you can receive the carry from the buying trade. This means that the swap you’d pay would be offset if you’re using an interday or longer-term strategy.

The bottom line: make sure you stop your loss

While pending orders might not be best for absolute beginners in forex, it’s clear that they can play an important role for intermediate traders as part of an alternative strategy to manage risk.

‘Be prepared’ isn’t just for scouts – the key lesson from comparing stops and pending orders is that however you do it, you need to have a ready way of limiting losses.

 

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