Forex Money Management – Stop Loss Order :
When developing a trading strategy a trader should firstly decide how much risk he is willing to take. Most professionals suggest that the maximum risk a trader should take is no more than 5% of the entire capital the trader has in his account on any one trade. So any stop loss position entails calculating the amount that represents 5% of the total funds in your account.
If your account balance was $10,000 then 5% would be $500. Hence every trade placed should have stop loss order placed which allows a maximum of $500 lost before being closed out.
Many traders create trading stops which are based upon high/low swings, or trend lines, or even Fibonacci retracement points. However, whatever way the trader develops his stop losses they should always be within the acceptable range of 5% of the capital in the traders account.
More advanced traders often widen their stops when the market is very volatile to avoid being stopped out too early in a trade especially if the prices spike. In these cases traders use Bollinger bands to help them place their stops outside the price movements that are can be expected according to historical price performance. Even though these stops may be outside the parameters of a 5% maximum risk strategy, these experienced traders still use sound money management techniques to protect their risk capital.
Stop loss order placement is the central pillar of forex money management and requires a strategy and set of rules that are viable and followed at all times. However aggressive a trader is it is important he maintains trading discipline and his trading capital is well monitored. Good money management is a survival technique which protects the traders capital and more importantly opens the door to good profits.
Using Stop Loss Order to Control Risks:
There are basically two types of Stop Losses: "Initial Stops" and "Trailing Stops":
- The initial stop is the one you put on your trade when you open a position.
- The trailing stop is a self-adjusting stop based on the on-going market prices.
To minimize and control your risks, it is very important to put a Stop Loss Order on your trade every time you open a position. The market can fluctuate over news releases on economy or political instability of some countries. They can cause unexpected sudden movements that can wipe out your account if you are not using Stop Losses.
So, the question is how much stop should be put on a trade?
The answer is "It depends". Because there are many factors that can affect the FX market, there is no easy single answer. For instance:
- The time frame you are trading in or the type of your trading style, such as a "day trader, swing trader or position trader", can all affect differently.
- Depending on the type of currency pair you are trading, your stop loss order may also change. For example: the daily range average of the EUR/USD pairs is 90 to 100 pips and this fact needs to be taken into consideration when deciding on how much stop loss to put on your trade, if you are trading the EUR/USD currency pair.
Deciding how much of a stop-loss to put on a trade is more of a personal preference than a science. Once you start practicing on a demo account, you will need to experiment with the stop losses and find the settings that work best for you. That having said, some examples of stop-loss settings are listed below as a general guidance.
In general, when you trade in the slower time frame like M30 or H1, your stop can be a little wider. On the other hand, if you are trading the faster time frame, the stop can be tighter. Below are the examples:
- When trading In a M30 (30-minutes) or H1 (1-hour) time frame using the slower Moving Averages, such as 9-EMA, 18-EMA, and 50-EMA, use a minimum of 40 to 50 pips for your initial stop.
In a M15 (15-minutes) time frame, your initial stop can be about 25 to 35 pips with trailing stops of 30 pips.
If you are trading in a M5 (5-minutes) time frame, use 20 to 30 pips for the initial stop.
In a M1 (1-minute) time frame, try to use tighter stops like 10 to 20 pips.
Placing a Stop Loss Order on Your Trade:
When deciding to enter a trade a trader has so many facets of the trade to think about that it is easy to over look some basic little things. One of these basics is a stop loss order and although it may seem a little thing it can make the difference between a good day trade and a bad one.
The Stop Loss is a tool which should be employed by all traders.
For example: if you bought EUR/USD 1 million at 1.3840 and set your stop loss position at 10% below the buying price you would limit your loss to 10%. That would mean that if the price of EUR/USD fell to 1.2456 the currency would then be sold at that price, loss of $138,400.
So as you can see the one advantage of a stop order is that you don’t have to keep checking on how a currency is doing. This is particularly useful when you are trading in one particular time zone and asleep while the markets in another time zone are open.
The disadvantage of a Stop Loss is that if it is not placed correctly it could be triggered by a short term reversal in the price of a currency. So the trick is to set your stop loss order in such a position that allows the currency to fluctuate in the short term without activating the stop while at the same time reducing your downside risk.
If your currency trading has a recent history of fluctuating by 100 pips on average daily then there is no point in setting your stop at less than 100 points as the trade will be closed out before it has a chance to make any money.
Of course there are no formal rules for setting stops but some logical strategies based on your own particular style of trading are worth mentioning.
- If you are a short term active trader then setting stops close to the entry price makes sense.
- However, if you are a long term trader then setting stops of 15% or more makes sense.
Perhaps a more positive way to look at a stop loss order is to think of it as a strategy to lock in a profit. This strategy involves using the Trailing Stop.