Correct Placement of Stop Losses in Your Forex Trades

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Correct Placement of Stop Losses in Your Forex Trades

One of the biggest things in trading is the placement of stop losses in your trades. Part of any money management system, stop losses orders bring discipline to Forex trades.

Many traders choose not to use stop losses orders. At all.

The reasoning isn’t that bad. They fear brokerage houses interfere with market activity. And, trigger stop losses orders intentionally.

The truth is that sometimes they do. However, not all Forex brokers fall into this category.

Market makers do tend to manipulate prices. Not all of them, but still.

When the broker knows the placement of stop losses in your trades, it may go for them. Apparently, it isn’t about any one trader, but the average positioning.

Managing the open Forex trades isn’t easy. Traders have different approaches, depending on what suits their personality best.

Because trading is mostly automated these days, the FX prices swing aggressively. All trading algorithms need is a piece of economic data or some central banker saying something.

Next thing you know stop losses orders get triggered, and retail traders wonder what was wrong?

Many things may have happened. For instance, setting the stop losses orders too tight is a reason for their triggering.

Hence, one issue with the right placement of stop losses in your trades is to adjust them to the timeframe.

In this article we’ll cover:

  • fundamental stop loss orders
  • proper placement of stop losses with different trading strategies
  • how to stop losses in Forex trading
  • what is the correct strategy of placing stop losses orders
  • best chart pattern analysis to set stop losses
  • tips and tricks in currency trading to help placement of stop losses in your trades

Many traders look at the market hitting a stop loss as a disaster. Is it?

Placement Of Stop Losses In Your Forex Trades

Interpreting Stop Losses

Any Forex trading strategy starts with planning. To manage future Forex trades, traders plan both the entry and the exit.

While the aim is to profit from every trade, the reality tells a different story. Losses are part of the trading game. And, they happen quite often.

The secret is to manage them. Or, how to react when they appear.

One way to deal with losses in Forex trading is to properly manage the placement of stop losses in your Forex trades. The starting point is to accept them. And, to view the good side of it.

This is, perhaps, the most difficult part to explain. However, when a trade ends up with a loss, some good things happen to the trading account. Namely:

  • the margin blocked by the trade becomes free
  • a new opportunity arises that may end up offering an even better trade

Hence, optimism should prevail. After all, if not optimism, what else brings traders to the currency market?

Stop Losses

Next, the focus sits with how to make the most of the winning trades. In other words, traders should have no problems when trades hit stop losses orders. That is, only if the ones that hit take profit levels have a bigger influence on the trading account’s outcome.

Money management comes to help. By money management, we refer to the entire trading strategy from planning to execution.

Forex Trades

Placing the stop losses to your trades should correlate with the take profit. They both form the risk-reward strategy part of the money management plan.

The risk-reward ratios aren’t the same for all markets. In Forex trading, a proper ratio has a 1:2.5 or 1:3 level.

More precisely, for every pip risked, the trader set to make two and a half. Or, even better, three.

Correct Placement of Stop Losses in Your Forex Trades

What is Forex analysis if not the right interpretation of market levels? One of the common mistakes in retail trading is to focus only on buying and selling.

Or, on the profit.

However, even more, important is how to handle the losses. Managing the stop losses orders is one way.

We already hinted a great way to find the placement of stop losses in your Forex trades. Using risk-reward ratios!

For instance, a great dilemma for any future Forex trades is where to set the stop loss order. Not all strategies provide the place for it.

However, it may be that traders know where they want to go out. Or, they know the target, but don’t know the proper stop loss.

Risk-reward ratios are here to help.

Traders know the entry of a trade in advance. At least this is the case for technical traders.

Either at the market or using a pending order, the entry is part of the known things in future Forex trades.

Besides the entry and the take profit level, trades know the desired risk-reward ratio. Based on it, they calculate the stop loss for each trade in particular.

For instance, if the take profit is ninety pips from the entry level, the stop loss order must be set at thirty pips. This way, a 1:3 risk-reward ratio assures all Forex trades follow the same money management rules.

The same rule applies to all stop losses orders set based on the risk-reward ratio. In fact, the correct placement of stop losses in your Forex trades must follow the risk-reward ratio and money management rules closely.

USDJPY Example of How to Set Stop Losses Orders

Theory alone is just that. It won’t help much in explaining unless practical examples follow. After all, chart reading skills must accompany even the most versatile traders.

Here is the USDJPY daily chart. It forms a possible pennant pattern that didn’t break. Yet.

Stop Loss Orders

As a reminder, a pennant is a continuation pattern. And, above all, it is a triangular formation showing price building pressure against a level or a trendline.

In this case, the 110 level seems to be crucial for further advance. However, even the bigger bulls need a stop loss for their trade. But where to set it?

As a continuation pattern, the pennant has two characteristics:

  1. it follows an almost vertical move
  2. it forms a triangular formation with the apex very close to the triangle’s end

The apex, as you may already know from previous articles, is the intersection point of the two trendlines. Imagine projecting them further on the right, and you’ll find the apex.

It seems that the conditions for future Forex trades on the long side exist. All traders need now is the entry level, stop loss and take profit.

The entry is relatively simple:

  • at market
  • placing a pending buy stop order at the highest point of the pennant

Proper Placement Of Stop Losses

For the sake of this article, let’s use the pending buy stop order example. In this case, the 111.45 is the entry level, and the 118.25 the target.

Those that don’t remember the rules of trading a pennant, the measured move equals the distance prior to the triangular formation. Plus, projected from the highest point of the pennant.

Armed with the entry and the take profit, how to find the right placement of stop losses in your Forex trades?

How to Calculate the Stop Losses Orders Levels

Using the USDJPY example above, the long’s trade take profit is set at 680 pips higher. That is, compared with the entry level.

For a 1:2.5 risk-reward ratio, the stop loss, or the risk, equals the target divided by 2.5. Or, 272 pips.

In the case of a 1:3 risk-reward ratio, the equivalent is the target divided by 3. Or, 227 pips, to round the number.

Is this enough for the future Forex trades following similar setups? The right answer is no.

When calculating the placement of stop losses in your Forex trades, one must consider the size of the trading account too. For, you see, stop losses don’t refer to the actual stop loss only. But, also the amount risked on future Forex trades.

For this reason, traders use proportional trading. Namely, they invest or risk only a percentage of the account on any given trade.

This way, they transform the number of pips risked into that amount. What results is the volume of a trade, determined in close relationship with the trading account’s size.

We already covered that subject in one of the previous articles here on the Forex Boat trading blog. If there’s a right time to check it, this is it.

Obviously, the bigger the risk-reward ratio, the better. One way to get the most possible out of the Forex trades is to use a trailing stop loss order. More about that in the next part of this article.

Trailing Stop Losses Orders

One great way to control the stop losses in a trading account is to trail the stop. That is, to use a type of order that follows the market.

Depending on the trading platform, a trailing stop order may or may not come with the default settings. In any case, if not, traders can import a custom indicator and use it.

Traders have two options. One is to set the trailing stop losses order to a number of pips.

Let’s assume a long trade and the stop losses order set at fifty pips. If the price of that currency pair rises, ten pips, or even one, the stop losses order follows suit.

Hence, the risk after placing a trailing stop losses order reduces with every step the market moves.

Trailing stops are a great way to ride a trend. While classic stop loss and take profit show a defined risk and reward, a trailing stop order shows a dynamic approach.

In other words, trailing stops give successful Forex exits. If the market keeps advancing without a pullback more significant than fifty pips, the potential reward will keep on rising.

Dealing with trailing stop loss orders differ from traders to traders. Some, as mentioned earlier, choose to trail pips.

Some others focus on a particular value. And other traders even look at previous closings. Either the closing of the last day or the closing of three days ago, and so on.

In any case, the trailing stop will follow the price action in close steps, until traders make the most out of a bullish or bearish trend. After all, this is the reason why trailing stop orders exist: to ride a trend until its exhaustion, with little or no risk at all.

Gaps or When Stop Losses Orders Fail

A stop loss order doesn’t work all the time. Or, it works but just in theory.

This is one of the major risks in Forex trading. Namely, the Forex broker can’t execute the stop loss order.

When the market moves so fast, it can happen. Or, when there is no market.

The brokerage house guarantees the execution if there is a market. But what if there is none?

Gaps in Forex trading don’t form often. Because the market is so liquid, there’s little chance that you’ll see it gaping during opening hours. That is Monday through Friday.

However, over the weekend, things do happen. Referendums, elections, summits, conferences, or just news that affects macroeconomics.

They all have the power to move financial markets. The currency market, apparently, is no different.

When a gap forms, the stop losses orders for your Forex trades won’t be executed. Instead, the broker will execute the orders when there’s a market. Or, at the market’s opening.

That’s really bad as the spreads widen during New Zealand’s opening on Monday morning. Moreover, liquidity is so poor that trading big lots would end up only hurting the trading account some more.

Other than at the Monday’s opening, gaps do not appear in Forex trading. At least, not usually.

The SNB Example

A classic example when stop losses orders failed, comes from the SNB (Swiss National Bank). To stop the CHF (Swiss Franc)’s appreciation, it pegged the value of the EURCHF cross to the 1.20 level.

Many retail traders took the SNB word for granted and placed stop losses orders at the 1.20 level. They were sure the long Forex trades would be stopped in the case the market moves below 1.20.

However, markets in the 21st-century use algorithmic trading. Robots, not humans, dictate conditions like liquidity, volume, execution, and so on.

It so happened that the SNB dropped the peg with no warning. And, it was not market all the way until 0.86 level.

Now, those hoping that the broker will execute the stop loss order got a cold shower. No market, no execution.

In any case, brokers spotted the danger of going after retail traders to recoup the losses. So, they took the loss on themselves and erased all negative balances.

But not all broker did that. Some did go after their clients and asked for them to come up with the difference.

During such unique trading conditions, no stop loss order can stop losses in the trading account.

Fundamental Stop Losses Orders for Your Forex Trades

Fundamental analysis is just another way of interpreting a currency’s strength. More precisely, traders use economic data and general macroeconomic conditions to analyze an economy.

Next, they act with conviction by buying or selling a currency. They express the sentiment by spreading the Forex trades across multiple assets. For example, multiple currency pairs that have that currency in their componence.

Many traders, tired of the small swings or lack of intraday movements, shift to macro-trading. One needs to understand economic phenomena before doing that, but even this is not impossible for the passioned Forex trader.

Typically, these trades have bigger accounts. Moreover, they aren’t likely to be retail traders, but professional, institutional ones.

They have more significant resources, a more prominent time horizon for their trades, and the stop loss order is not mandatory to be a fix level in the market. Most likely though, the stop losses order is based on the fundamental news too.

Hence, traders in this position won’t close a trade unless something in the fundamental picture changes. Interest rate levels, shifts in monetary policy, geopolitics, etc., are reasons good enough to cause the closing of the opened Forex trades.

In any case, a physical stop loss when macro-trading is unlikely. Instead, traders shift gears and positions when the global economic picture shifts gears and positions.

Conclusion

The placement of stop losses in your Forex trades is subject to each trader’s risk appetite. Aggressive traders won’t use such an order.

Instead, they’ll scale or even martingale a position until the trade makes sense, or it doesn’t anymore.

Conservative traders follow a more conservative approach. They use tight trailing stop orders to minimize the stop losses and watch the market carefully.

Long-term traders and investors are likely fundamental traders. Macroeconomics drive their judgement, and the stop losses orders come from the same fundamental picture.

All in all, a breaking point exists in every case. The line that cannot be crossed. Or, the red line.

Every trader knows what is the limit to push against. That is, the limit until trading still makes sense.

The problem is that there is a thin line between bending the rules and bending the trading account. Controlling the stop losses in a Forex trading account keeps a realistic approach that guarantees survival in the long run.

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Damyan Diamandiev
Damyan Diamandiev

Damyan is a fresh MSc International Management from the International University of Monaco. During his bachelor and master programs, Damyan has been working in the area of financial markets as a Market Analyst and Forex Writer. He is the author of thousands of educational and analytical articles for traders. When being in bachelor school, he represented his university in the National Forex Trading Competition for students in Bulgaria and got the first place among 500 other traders. He was awarded a cup and a certificate at an official ceremony in his university.

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