The Main Things You Need To Know About The Stop Loss In Forex

Mar 1, 2021 08:03 PM ET
The Main Things You Need To Know About The Stop Loss In Forex

The stop loss is a simple trading concept in forex but often comes with dangerous misconceptions and illogical mistakes. Correctly understanding this idea is the framework for solid money management and risk to reward. 

This article will cover the main crucial things that any trader should recognize about the stop loss in forex.

Debunking a few myths about the stop loss in forex

Gaining better knowledge about the stop loss means ridding a few misconceptions in the prevalent trading literature.

You can trade without stop loss

A common belief of many traders is the possibility to trade consistently without stop losses. Such an idea is built on the premise that stop losses are the enemy or that brokers' hunt stops.' 

While 'stop hunting' exists (though it is preventable), a stop loss in any leveraged market is 'make or break.' Without using one, no trader can accurately position-size. 

When observing the lots to trade on any given position, you will naturally consider the maximum risk you are willing to take, which necessitates knowing the stop loss distance. No one should arbitrarily choose a position size.

Unless a trader uses tiny lots like 0.01 with a substantially large trading account, they could get away without a stop loss. Though even then, they could stay in a losing position for an indefinite period anyway. 

A stop loss is the only method to prevent a substantial unforeseeable loss with very little manual intervention ('mental' stops are no solution). It also allows a trader to remove any emotional attachment to a position, making it easier to move on and find new opportunities.

Brokers' hunt' your stop losses

As mentioned previously, 'stop hunting' is a phenomenon often spoken about in trading circles but wrongly attributed to brokers. Firstly, from their perspective, it would negatively impact their reputation.

While a few unscrupulous brokers can manipulate a trader's orders, in most cases, 'stop hunting' occurs from market dynamics by institutional traders.

There is no real evidence of these traders actually performing 'stop hunting,' though by looking at the charts constantly, we can observe instances where it does occur. Several types of pin-bar candles in specific areas are perfect examples. 

Traders often place stop losses in detectable levels or places with no solid reason, which is where 'stop hunting' happens.

Wider stop losses mean more risk

A wider stop loss does not equate to an increase in risk if we grasp the concept of position sizing. Two traders risking $100 each can have a 50 pip and 100 pip stop depending on their trading style, the set-up, how long they plan to hold the position, etc. 

We can see that the risk remains the same, even though the stop loss distance in one instance is higher.

The stop loss builds the framework for risk-to-reward

A stop loss is not just a mechanism for managing losses but the framework for risk-to-reward through position sizing. In every position, a trader has a pip target estimate and compares that to the distance of their stop. 

If the stop loss is too wide, that naturally reduces the reward unless they are swing or position traders who plan to hold for an extended period. In contrast, if it's too tight, although this can increase the potential gain, not all strategies benefit from a smaller stop loss, especially if a trader has not considered each instrument's volatility.

There can never be a recommended stop loss distance; it all boils down to experience and observing what works for each strategy. Another critical factor is every position necessitates its own stop loss distance. Consequently, this means that the potential reward cannot always remain the same as the market structure will differ.

Common mistakes with the stop loss (and how to avoid them)

Based on the feedback from numerous successful traders, we have collected some of the common pitfalls traders face when using stop losses below.

Using the same stop loss distance or position size on every position

Each forex pair moves an average volatility range for every time-frame. A 30-pip stop on EUR/USD weighs more on a highly liquid and fast-traveling pair like GBP/USD or GBP/CAD. 

If we frame it differently, a 0.10 position on USD/JPY is not worth the same as GBP/JPY. This distinction is one reason why the stop loss and position size should vary on a trade-by-basis. 

The simple solution here is using a position size calculator to accurately calculate the position size according to the monetary risk.

Too tight or too wide a stop loss

A stop loss that is too tight is often a result of greed (by desiring a bigger position size) or not understanding market volatility. There are some strategies and trading styles that work with tighter stop losses than the norm, though these are the exceptions. 

Conversely, a wide stop loss isn't recommendable except for long-term traders who plan to stay in positions for very long. More short-term traders can consistently use wider stops, though the reward goes down significantly. There is no universal law on the correct stop loss distance. 

However, any individual aims to find a balance between the highest possible reward while setting a stop that allows 'breathing room' before a market definitively invalidates their trading idea. This will only come with experience and extensive forward-testing.

Widening the stop loss

This issue is merely a lack of discipline and strictness. Widening the stop loss when a position goes against someone unnecessarily increases the risk; there is rarely a logical reason for doing so. The only solution for this mistake is merely having a strict trading plan and practicing discipline.

Setting the stop loss is a thoughtful process occurring well before an order is executed, considering that the trader fully accepts the potential for loss or the worst-case scenario. 

Not accounting for the spread

This factor may seem small but is essential nonetheless. 

Before opening any position, whether a broker uses a fixed or a variable model, traders should know each pair's spread by observing them on their trading platform.

For example, if the spread on USD/JPY is five pips and the original stop loss distance is 20 pips, the eventual result would be 25. On exotics, which naturally have higher spreads, this becomes increasingly vital and ensures a trader is not 'kicked out' out of the market consequently.

Conclusion

Fully grasping the concept of a stop loss can be a year's course on its own. It's a simple idea, yet there are many subtly complex factors that one should understand thoroughly to avoid the common pitfalls and misconceptions. 

Ultimately, a stop isn't just about managing losses but also forms the framework for position sizing and risk to reward in forex.

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