You’ve decided to take forex trading more seriously.
You won’t regret it.
Now, let’s turn to stop losses in this lesson. You might be thinking, ‘Why do I need to know or learn something so basic?’ The short answer is, most traders fail to understand the art of stop losses. If you want to be a consistently profitable forex trader, you need to master the following tools.
First, at the start, it’s best that you learn to trade forex with stop losses.
Basically, a stop–loss order is exactly what its name suggests — it’s used to stop losses. If your forex trades go in the opposite direction to what you want, stop losses will ensure you’re ‘stopped’ out when the price reaches your maximum loss. It’s important to use stop–loss orders for your trades to minimise your losses. Otherwise, the outcome can be devastating.
Every pro forex trader uses stop losses for protection.
For example, let’s pretend you buy the USD/EUR currency pair at the price of $1.00. You have a target price of $1.10. A wise trader will place the order with a stop loss at $0.95, so that if prices fall below that range, your trade will be closed out immediately. If the price of the pair goes up, you’ll earn a profit. The maximum profit, in this example, is twice your risk amount.
There are two reasons why you should use stop losses when trading forex.
Firstly, it will allow you to carefully manage your capital.
Stop losses will help you minimise losses and increase gains over the long run. A pro trader is an elite money manager ― don’t ever forget it.
Secondly, if a currency pair falls too much, a stop loss will limit your losses and allow your trading account to survive for another day. Remember, while small losses hurt, big losses can be career–ending. Stop losses keep your account going so that you can keep on trading, and hopefully become a consistently profitable forex trader.
A word of advice: Don’t keep changing your stop loss. That’s a rookie mistake. If you do this, you will likely turn a small loss into a big loss. Small losses are okay because they are a cost of doing business.
It’s key to understand the market that you’re trading.
All markets are different.
If you understand a market’s price action, you will see trends and turning points in that market. Once you’re familiar with the market structures, it will be easier to set your stop losses when trading.
Make life easier for yourself.
Remember, being familiar with different types of markets will give you more knowledge. In some markets, you’ll be able to trade more strongly; others won’t suit your style. Understanding different markets will make you a better forex trader.
Easier said than done, right?
Understanding different markets takes patience and careful study. It’s important to not assume anything and, when you’re trading, you don’t want to set stop losses at any price. That’s another rookie mistake. Think about it. If you spend lots of time trying to find great entries, then spend the same amount of time deciding where to place your stop loss.
Your stop loss is equally important.
Choosing where to place it dictates whether or not you will become a consistently profitable trader.
Don’t underestimate using stop losses.
I’ll say it again: An elite trader is an elite money manager.
Trail your stop loss
The trailing stop is another good tool that you can use in forex.
Trailing stops are used to increase profits, as the market moves in the direction of your trade, without you having to step in and make adjustments all the time. This tool will let you follow trends to rack up enormous profits. The best thing about trailing stop losses is that you won’t have to keep an eye on the trade all the time.
I know many forex traders who use trailing stop losses.
When you start trading forex, you might use trailing stop losses from the get–go. If you do, don’t forget that you can take profits when the price hits your target as well. But if you want to hold on to your trade, hoping that the prices hit the next key level, you can let your profits run by using a trailing stop loss.
Just know, you shouldn’t change your mind midway through a forex trade, in terms of whether to use a trailing stop loss or not. Decide if you’re going to use it when you enter a trade. Remember, elite traders know when to buy and sell ― before a trade. Perhaps the forex trade doesn’t work out, but they still trade according to their plan.
A trailing stop loss works because you are able to lock in profits, if the trade reverses quickly. If the forex trade continues to run in your direction, you can make more money. Keep in mind, when using trailing stop losses, you will continuously ― and automatically ― modify your stop, which means you will be at risk of getting stopped out early.
That’s a risk.
For example, let’s pretend that you buy the USD/EUR currency pair at the price of $1.00. You have a target price of $1.10 and set your trailing stop loss at $0.95. Say the trade goes in your favour and the price hits $1.05. Your trailing stop loss will likely be adjusted to $1.00, if it’s automatic.
If so, and the trade reverses to below $1.00, you will be stopped out.
To avoid this situation, you can use normal stop losses or set a manual trailing stop loss. However, we don’t recommend setting stop losses manually at the start. It’s too easy to change your mind. Your job at the start is to become a consistently profitable trader. That’s your goal. If you become an elite trader, you will have earnt the right to play around with your stops.
Note: When a forex pair is in a ranging market ― i.e. hitting the same support and resistance levels multiple times ― your chances of being stopped out prematurely rise significantly. It’s the same thing for a sideways market ― i.e. when prices remain within a tight range for a long period. At the end of the day, trailing stops work better in trending markets.
Support or resistance areas for swing traders
For example, swing traders tend to make most of their money in trending markets. Swing traders buy when the price dips, and sell when the price spikes. The question is, if you’re going to become a swing trader, where do you place your stop, if there’s a major support and resistance area?
Don’t place your stop where it’s obvious, such as round numbers.
Remember, pro traders study and understand the broader price action story ― not just the current action. Say that the price action is in a consolidation zone. Before the price goes the opposite way, it usually makes a serious of ‘fake’ breakouts in both directions to trick traders. Newbies buy into these ‘false’ breakouts and end up losing lots of money.
The short story is, you need to think carefully about the price action. Specifically, if you see a series of ‘false’ breakouts, what’s the greatest probability of the price breaking out in that direction?
It takes practice.
For now, beware of false ‘alarms’!
The price action usually just goes slightly above, or below, major support or resistance areas before it returns to the consolidation channel. Sometimes it takes three to five times ― or more ― for the price to truly break out. The more you see ‘false’ breakouts in action, the more you will be able to accurately judge the probability of the direction of the ‘true’ breakout.
Your ‘Start with Forex’ takeaway
On that note, we said above that rookies set stop losses at round numbers or close to major support and resistance areas. Knowing that the price tends to make a series of ‘false’ breakouts when it’s in a consolidation zone, you can see why so many traders get stopped out and lose money.
So, where do you place your stop loss?
There’s no right answer.
As previously mentioned, it takes careful review of the current and broader price action.
It might sound confusing.
But, as we’ve been outlining throughout this course, keep your trading simple. For example, if you’re trying to ‘fade’ a trade in the opposite direction to the broader trend, you can place your stop slightly above the nearest major high or low. Alternatively, if you’re in a momentum trade, you can place your stop under the recent major low.
Setting stops is an art and a science.
I hope that you found this lesson useful. Elite forex traders trade with stop losses ― they keep their losses small and let their winners run. In the next lesson, we’ll give you our tips on how to keep a forex trading journal. If you want to know how to use a forex trading journal to your advantage, click here.
To your trading success,
Start With Forex
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