Renowned American journalist John Marion Tierney introduced a concept that is becoming more and more prevalent in the hectic world of the financial markets. His idea known as “decision fatigue” refers to a state in which you can no longer make sound and reasonable decisions because you have already made so many over the course of a day.
Of course decision fatigue can play a significant role in the biggest financial market in the world, the foreign exchange market. In the forex market traders are making decisions all the time – sometimes every minute or even second. Making so many decisions can naturally lead to this state of mental fatigue.
There are many tools and techniques to help traders make better decisions. One of these concepts are the stop loss orders.
A stop loss order can come to your aim when you most need it in order to save you from incurring heavy losses that would have otherwise gone unnoticed.
So this article is dedicated to this unsung hero of forex – the stop loss.
Definition of Stop Loss in Forex
Suppose you have taken a long position. Now wouldn’t it be nice if your position would close automatically when prices hit an ideal high? Better yet, further suppose you have taken a short position. Wouldn’t it just be dandy if your position closed itself when prices get to a low threshold after which you would lose money?
These situations are examples of stop loss orders, which are essentially orders you have previously set in order to buy or sell at a particular price. So basically, a stop loss order helps you avoid losses as much as possible. In fact, it is one of the most readily available and perhaps highest recommended basic risk management methods in forex.
So for example if you are trading a currency pair in forex and buy one currency denominated by the other, you can set a stop loss of 5% which would limit your losses to a maximum of 5% no matter what.
Of course, depending on the conditions of the trade and the over trends in the market(trend trading), the stop loss can be placed at various levels. If things are moving well, the trader might give himself or herself more breathing room and set a higher stop loss.
While, if stakes are high and the conditions are riskier than usual, the trader can choose a tighter stop loss to limit losses to an even greater extent.
How Can Forex Traders Benefit from Stop Loss?
As was mentioned before, stop loss orders are readily available to any trader. This is precisely one of their most important benefits that they can offer to all. The fact that they are just there, free of charge and all.
All trading platforms and brokers offer stop loss orders. It is an inseparable part of trading in all financial markets, including forex.
So this is one of the most important aspects of stop loss. It is accessible by any trader and can be set with only a few clicks.
Another important aspect of stop loss orders is that they free you up from the burden of making decisions in the nick of the time. Although more importantly, they relieve traders of a much more demanding and time consuming aspect of trading as well – full time observation of the market.
You can set the stop loss orders and rest assured in the knowledge that even if you do not have access to your trading platform when it is most necessary, your assets will be fine.
This will be especially beneficial in situations where you have no choice but to stay away – such as emergencies or when you simply do not have access to the internet.
On the other hand, stop loss orders in forex can eliminate the subjective errors made out of the involvement of emotions in trading. It is natural to get rather emotional while trading. One particular emotional trap that forex traders get stuck in is when they “marry” a position, as they say.
This is when the trader gets absolute tunnel vision and simply cannot see the circumstances clearly for what they are. Thus they are not able to move on from a certain position, be it long or short.
But the use of stop loss orders will remove the emotional interferences in the trades by automatically saving the assets from going too far into the losing side.
Plus, stop loss orders can help you execute your trading plan better and with more discipline. Since without a stop loss your trades might sustain losses and force you to abandon ship, when you are actually close to the only land in sight.
This is where stop loss gives you the ability to stick to your trading plan and see it through in the market.
Though keep in mind that stop loss orders are not going to eliminate loss altogether. As a trader, you must always be alert and aware of price movements.
Can Stop Loss Orders Be Disadvantageous for Forex Traders?
Of course like any other method, technique, and approach in forex trading, the concept of stop loss orders is not without their downside.
We briefly talked about picking the right stop loss threshold above. But if chosen incorrectly, then you would be faced with one of the disadvantages of stop loss orders.
You see, sometimes price movements could be mere corrections or even short term volatilities. In either case, basing a serious decision on them would not be a wise choice.
But if the stop loss threshold is chosen tightly, then even a slight volatility could trigger it. So it is highly imperative that you choose the stop loss in a way that it is not triggered easily. Especially in a highly active market such as forex, where volatilities are to be expected at all times.
Another potential disadvantage of stop loss orders can be the time difference between the stop order and the limit order. This can be especially detrimental to traders in fast paced markets such as forex where prices could go up and down very quickly. So in this case the stop order can stop your position from going into loss. But by the time the limit order is actually carried out in the market, prices may have well changed.
One of the best tools to manage risk and loss in forex trading are stop loss orders. With the help of this tool your position would be closed, either a long or short position, when a certain price threshold is hit. A price threshold, by the way, that the trader has set prior.
No matter what trading style and strategy you implement – whether you are a day trader, scalper, or even a swing or position trader – it is always highly recommended that you implement stop loss orders to properly manage the risks involved with forex trading.