A Forex stop loss order is one thing you must know how to use if you’re trading currencies.
Let’s start with its basic definition.
In financial markets, we have different types of orders.
Market orders, pending order, good-till-canceled orders, etc.
Each order serves a specific purpose.
However, many people would be hard-pressed to argue against the importance of the stop loss order.
But what is it?
A stop loss is an order to close the trade once price has gone against you a certain amount.
For example, you can enter a long currency trade with a Forex stop loss 50 pips below your entry price.
In doing so, if the market moves against you (pair price moving down), you can avoid major losses by having the trade close when price moves down those 50 pips.
If you don’t place a stop loss order, you leave yourself wide open to losses.
So a stop loss is basically a risk management mechanism. And an effective one at that.
The use of Forex stop loss orders isn’t very different from its use in other financial markets.
I’m calling it Forex, but it’s just a stop loss used in the FX market.
Great, with that out of the way, we can talk more in depth.
What happens if price moves against you, breaks your stop, and then bounces back towards your goal?
Too bad, sh$t happens…
is often called stop-hunting.
When other (bigger) market participants enter a trade in the opposite direction, before placing a much bigger order in the direction they want.
Time for an example:
You’re going to trade into Non-farm payrolls (NFP) --let’s assume we’re doing this, for illustration purposes.
Market sentiment around USD is strong, so are the big-picture fundamentals, and on top of that, employment figures are expected to come out considerably better than previous figures, according to consensus.
The FED is likely to hike on its next meeting if the labor market tightens, so the market is intently waiting for this NFP results.
To top it off, the perceived strength of USD is only matched by the weakness in GBP at that moment in time.
For argument’s sake, let’s assume Brexit was just announced and the markets were shocked (shockingly shorting pounds, that is).
Under this scenario, trading into NFP by shorting cable (GBP/USD) is quite the high probability trade.
However, you never know what kind of crap can go down, so you always place a Forex stop loss order just in case.
Since this is such a clear wash, you decide to use a tight stop (say 20 pips).
What happens afterwards is something you will never forget.
About 10 seconds before NFP figures come out, price suddenly moves sharply in favor of cable.
The move takes about 22 pips and you get stopped out.
Price reverses completely and shoots the hell down.
A shooting star would be envious.
As the market moves 100, 200, 300 pips down, you pull your hair in agony:
How could this be!?
I did the right thing!
Why was I stopped!?
So much money!
I made those pips!
And so a cult was born.
The cult of the anti-stop hunters.
You see, a stop hunter is someone who manipulates price in super-short term to squeeze out small traders before a move takes place.
But in truth, these demonic beings aren’t really out to get you.
They aren’t demonic either.
It’s not that someone’s out to get you.
Rather, let’s think of it from the point of view of an institutional investor.
Think pension fund here, with billions of USD to place.
If you decide to enter the market with such a crazy amount of money, you will experience slippage.
In other words, as you buy a pair, price will move up (because of your big order), and thus, most of your big order will end up being executed at a higher price than you placed it.
With a big pile of cash, you will have lost quite a good amount of cash on this simple “slip” (see what I did?).
To counter this effect, large investors first enter in the opposite direction.
Thus, if they want to go long, they will short first, driving prices down, before going long with the whole position (thus, getting a better overall price for the total placement).
An unsuspecting retail trader would be surprised!
But it’s nothing personal.
Ok, so what can we do, both to combat stop hunters and any other threats?
First, the biggest threat to your account, and therefore you, is a large swing against your position.
Therefore, the first order of business is placing a reasonable Forex stop loss order with every single trade you take.
How large should the Forex stop loss (SL) be?
Your SL’s size will vary depending on what trading strategy you’re using.
If you’re holding a trade for the day, a 30-60 pip should be fine.
If you want to hold a position for several days, then 100 pips sounds more reasonable.
Why not less than 30?
Because your stop might get hunter, and even if it doesn’t, you’re not giving the trade enough room for price to move.
Thus, if you insist on placing unnecessarily tight stops, you will end up with a huge drawdown.
Not even taking into account all the profit you didn’t get because you were stopped before price did what you knew it was about to do.
Of course, these SL recommendations don’t hold if you’re scalping (you need a super-tight SL).
And if you’re doing something different which requires a slight bend on these rules, that’s another valid reason to depart significantly from these guidelines.
Of course, you should always take into consideration technical levels to serve as extra “shields” between you and the markets.
As in, placing your SL below a (or two) strong support zone(s) in a long trade.
This way, it’s likely price will bounce back up before it stops you out.
See you soon,
The Forex Economist
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