What is a Stop Loss?
Protecting your capital is the most important task in forex trading. All trading carries risk and no currency trader can make profits all the time. Preserving your capital to allow you to trade again and recover any losses is essential for success.
Stop loss orders protect capital by specifying the minimum exchange rate you will accept. Effectively, they set a floor price on your trade. Should exchange rates move against you, the stop loss will close the trade at the rate you specified – shielding you from further losses.
How Does a Stop Loss Work?
Think of it as your emergency brake. The whole point of forex trading is to make a profit. However, sometimes the market has other ideas and rates may move against you. This is when your stop loss can save the day. If rates fall, your stop loss automatically buys or sells to close the trade if and when your specified rate is reached.
Many trading strategies will set the stop loss a few pips below the lowest rate you will accept. This may allow you to remain in the trade instead of being closed out should volatile currency movements push the rate down - only to see it quickly bounce back. Additionally, a stop loss doesn’t only preserve your capital in the event that rates keep dropping, it also saves you from being glued to your monitor. Just set it and forget it.
An Example of a Stop Loss Order
George wants to buy US Dollars (USD) at a rate of $1.16. However, the market is volatile, so he sets a stop loss at $1.1485 in case the rate moves against him. Instead of moving up to $1.16, the rate falls. As soon as it reaches $1.1485, his stop loss order automatically sells his position and closes the trade. More importantly, as the rate continues to drop, George is safely out of the trade and protected from further losses.
Benefits of Stop Losses
- Protect capital from unacceptable loss.
- Automatically exit an adverse trade as soon as the stop loss is reached.
- No need to monitor the market continuously.
- Can offer a safety margin to keep the trade open and capture a price bounce back.
Disadvantages of Stop Losses
If there is insufficient safety margin, short-term fluctuations in exchange rates could activate the stop loss and you may miss a rate bounce back.
Protection As Vital As Profit
Protecting your capital is key to forex success and a fast exit can sometimes be the best solution. For investors and businesses alike, stop loss orders are the number one tool for this task. If in doubt, remember: He who stops and turns away, gets to trade another day.
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