Many traders really don’t give a damn about managing their risk when it comes to trading the FOREX markets. The thoughts of profit making on their investment is always the first thing clouding their minds and happens to be their main priority. You see successful traders have the reverse psychology when it comes to trading on financial markets. Safe-guarding your capital should be your number one priority, you must device all means to manage your capital. When i hear a lot of stories about traders who blow their accounts within a couple of trading transactions, i keep wondering how it happened. Then i say to myself, ‘i have been through that path too’. I remember how i blew my $4,000 account within 24 hours. The major constraint behind this is not using a ‘STOP LOSS’ to protect one’s account from risk. This article will be based on understanding the function of stop loss in trading.
A stop loss is an order that closes out your existing trade in order to limit losses when a trade goes against you. Stop losses are literally used to stop the loss of your trading capital. When your stop loss order is hit on a trade, the trade is closed at the market value the trader specifies. A stop loss helps tremendously in managing risk and is vital in money management plan in FOREX trading. This enables traders taking the emotion out of trading decisions. Moreover this removes baby-sitting of trades which makes most traders emotional when watching the fluctuation of price movements. However, execution of stop losses is not 100% guaranteed, particularly in situations where a fundamental economic news report is released or weekend gaps in price occurs.
Typically there are two types of stop loss model namely the automated stop loss and the manual stop loss. The automated model is a pre-determined stop loss type that involves the input of price value where loss should be limited automatically by the FOREX broker as specified by the trader. However in the manual stop loss model, the trader closes his/her position manually when the trade goes against his/her direction. Hence manual stop loss needs close monitoring of the position and requires baby-sitting of trades. We also call this type of stop loss ‘psychological stop loss’. Both stop loss model has its own advantage and disadvantage, using any of these type of stop loss depends on the trading system a trader is using.
When using automated stop loss in trading, sometimes price comes to take your stops and then starts to go back the direction you earlier predicted, this can be really frustrating. However if you are trading a sound strategy, this scenarios wont be happening every now and then. The basic fact is that you cant escape this kind of occurrences in currency markets, all you need to do is deal with your emotions when this happens. Manual or psychological stop loss is very cool to adopt into trading systems as your trades wont be getting hunted by the market makers since you are using an exit rule as your stop loss. However i have seen trading scenarios whereby an exit rule can give you a threefold loss than you would have lost if an automated stop loss had been used. Lets say for example you are in a trade and then an economic news is released into the markets that drives price crazily against your direction. Imagine how much would be lost, even this can wipe an entire account! Even sometimes automated stop loss can be gaped in this kind of market scenario.
Remember, the point of the stop loss is to end the trade when the market goes far enough in the opposite direction, that your trade no longer makes sense. It can be difficult facing the fact that you made the wrong decision, but the markets are as unpredictable as the weather. Sometimes you look at things expecting what seems obvious, only to have the market behave unexpectedly. Do not feel bad when you loose a trade, even the greatest traders have loosing trades. Focus more on long term results like monthly or weekly outcome than present trading results. No matter what stop loss strategy you choose, remember not to move your stop loss further out to prevent the trade from being stopped out. This is why i prefer the automated stop loss model as sometimes the manual or exit rule stop loss can be tricky and play pranks with traders emotion. It gives the feeling of hope that price will return back your favor which is a wrong approach to trading. There is no hope or faith in FOREX trading. Its either you get it right or you are wrong. This is a major factor that wipes a lot of trading account in FOREX trading.
When coming up with your stop loss strategy, just remember to set stops that make sense for your account and trading style. The whole point is to limit your losses when you are wrong. If your losses continue to be excessive or your stops are constantly hit, you may need to rethink your system.