The success rate of any currency trader strongly depends on the risk managing techniques. We can’t avoid risk altogether, but we can find smart ways to minimize the damage and gain the most out of each trade with the help from tools like Forex stop loss, for example. Today we are going to discuss the different types of stop losses in Forex and how to effectively use them during trading.
What Are Forex Stop Loss Orders
Let’s start with establishing what is stop loss in Forex. Unlike many aspects of risk prevention in currency trading, stop loss is a very straightforward tool. It does exactly that: stops losses.
Foreign exchange market can be very fast-paced and volatile. Even if your analysis is extremely thorough and your strategy has always worked in your favor, there is always a chance of things going South.
Smart traders know that avoiding the risk means not actually trading. That’s why there are multiple instruments and techniques to help deal with the possible drawback. Stop loss in Forex is a type of order, designed to stop the trading process automatically when price movement begins to get too much out of hand.
Now, the technicalities of this process may vary depending on what type of Forex stop loss is used. The simplest of them all is the regular stop loss order. It is used when a trader wants to cover the rear by indicating at which particular point the trade should stop.
Stop loss Forex tool comes in two main types: sell stop and buy stop. Once again, it is all pretty self-explanatory: sell stops are securing the gain during long positions by activating an order when price goes below the specified level, while buy stops do the same for short positions in case market price escalated beyond the expected limit.
A trailing stop loss Forex tool is a slightly more interactive version of the regular one. The order will move along with the price if it goes in the opposite direction from it, however if the price towards the limit in either direction, it won’t move. This way traders have a chance to benefit from higher profits, while still ensuring that there is enough security behind the trade.
There are two major challenges associated with using stop losses in Forex. One of these is insignificant price fluctuations that can trigger the stop order too soon, in case it was located too close to the price. The solution for this type of scenario is to learn how to calculate stop loss in Forex for every particular strategy and currency.
Another issue traders face while using stop loss orders is gaping. Let’s take a couple of moments to fully understand what is the gap and how we can properly deal with it.
WHAT IS THE GAP IN FOREX TRADING?
Gap in the market will look very unusual to those who just started understanding the mechanics of chart formation. It is an empty space in the price movement with drastic difference at its both ends.
This happens when a large value leap occurs with little to none trading volume. Gaps appear for a number of technical and fundamental factors. These factors can include the discrepancy between supply and demand, unexpected economic report releases, the end of a trading week and so on.
The biggest threat for anyone who is using automated orders is that their limit specifications won’t get fulfilled due to the gap. Reason behind this is that the requested limit just doesn’t exist on the chart due to the significant leap.
Since we already know that the regular Forex stop loss order is not an effective tool against market gaping, there is a need for an advanced version of it. This is where the guaranteed stop loss (GSL or GSLO) comes in.
What Does Trading With Guaranteed Forex Stop Losses Represent?
Guaranteed stop loss in Forex is a rather rare tool. Not many brokers provide it as a part of their services due to the complexity of implementation. However, it proves to be significantly effective in a number of gaping scenarios.
In most cases market gaps tend to fill in overtime. It is the simple logic of an equal number of sellers and buyers that always strive for a balance. But there are also times when increased volatility brings permanent gaps, such as the events of the 2008 crisis.
So, the guaranteed stop loss Forex order will serve as kind of an insurance. By using the advantage of guarantee, a trader can be sure that the order is going to be filled at the specified price disregarding gaps and high volatility.
When we say insurance, it means exactly what it sounds like: it is nice to have it, but hopefully you won’t ever need it. Why is that?
Guaranteed stop losses in Forex have a set of conditions that go along. As we already mentioned, brokers do not usually offer a guaranteed stop loss order tool. Instead, it is sourced from larger market makers, which are normally uneasy to approach.
Additionally, there are going to be multiple limitations on how you can use guaranteed stop loss. For example, you might be required to place the GSL within an indicated time period. It can also not be placed more than 5% from the current closing value.
Last but not least, there is a price you have to pay each time you want to use a guaranteed stop loss order as your risk preventing tool. While the regular stop loss is unlimited in terms of how and how many times you can use it and doesn’t cost you a lot.
This brings us to the next question: with so many issues around GSL, why is it still something we might want to consider? Well, there are certain benefits.
WHAT ARE THE BENEFITS OF USING A GUARANTEED STOP?
So, at this point we know that guaranteed stop loss order can be looked at as a type of insurance. It serves as a preventive measure in a number of difficult scenarios, but comes with several downsides.
Just like any other risk management solution on Forex, GSL has both pros and cons. We have already discussed some major cons, and now it’s time to talk about the good points.
Volatility can be brutal. Even the most experienced Forex traders can be overwhelmed with some markets. Guaranteed stop loss is not going to change the way the market is progressing in any way. But it will shield your account balance from the aggressive hits.
A regular stop loss order cannot activate during gaps, because it has to be physically filled in by the broker. Paying for a GSL provides a unique opportunity to stay certain about carrying minimal losses even during the most uncertain times.
Guaranteed stop loss works in both directions, meaning that it can serve as a safety cushion for both short and long positions. It is important to note, however, that you will not be able to use a GSL on an existing position. Stop losses of this sort only work on new positions and cannot be undone, although you can adjust the level on which it is located.
Setting a guaranteed stop loss can significantly reduce your losses. While you are still going to face a decline in your balance, it is going to be much less than the one you would have without placing a GSL. Later on, we are going to look at the specific example of how much money can be preserved through placing a guaranteed stop loss order.
From this we can also draw to a conclusion that a trader who uses GSLs can anticipate the risk significance in advance. A big part of how to calculate stop loss in Forex is finding out what exact amount is at risk. But in volatile markets this calculation might not always be correct. In such cases, a guaranteed stop loss is nearly the only tool that will actually be effective.
Finally, with the implementation of a guaranteed stop loss, the trader does not have to be in control the entire time. Watching a fast moving chart can be very stressful. And escalated stress always leads to poor decision-making and faulty analysis.
Traders who choose to exit manually might get affected by a number of very human emotions, such as greed, panic, anxiety, indecisiveness and more. And once any of those feelings takes over, it is either exiting too early or too late, but never on time.
A guaranteed stop loss eliminates a large part of stress, by minimizing the potential losses. Plus, the trader doesn’t have to worry that a specific price level will be skipped due to gaping or volatility.
Just before we wrap up, let’s look at the GSL order in action and break down an example of how it can be used during trading.
Guaranteed Stop Loss Order Example
We know two things: a guaranteed stop loss order will absolutely be filled at the requested price and it also significantly minimizes the lost amount. This means that you can be sure that you will not lose too much, but you will still lose some.
In the following example, let’s look at three risk management techniques, including: no stop loss aka going with the flow, a regular stop loss and a guaranteed stop loss order.
Now, we are going to look at the scenario of buying USD/EUR for $10 per point at 11026.5. Then a random gap occurs and the price drops to 10073.7, what happens to three different trades with various risk preventing tactics.
In the scenario of no stop loss orders whatsoever, a trader will have to face the entire set of consequences associated with the drop. That way, considering the difference between the prices and multiplying it by the cost per point, the total loss will come to $9,528.
Next, let’s look at the situation, when the regular stop loss was placed at 10950.0, but a slippage occurred and the order was actually executed at 10860.0. As a result the loss is slightly less significant and comes to $1,665.
Finally, we are going to test the guaranteed stop loss order in action and set it at the same level as the regular stop loss from the previous stage, 10950.0. Since there is a guarantee in place, the order gets filled at the exact number, bringing the total losses to $765.
Depending on your overall account balance, $765 might still be a visible decline. But as soon as you compare it with nearly $10k from the no stop loss example or $1,665 with a regular stop loss it starts to make a difference.
Considering this example, it is safe to say that a guaranteed stop loss can play a really important role in the risk minimization process. However, traders should not disregard other ways of safeguarding their assets.
Risk management in Forex trading comes in a variety of solutions. From portfolio diversification to specific trading limitations or uniquely developed trading strategies. If you are not comfortable with all the requirements of the guaranteed stop loss orders in Forex, make sure to adopt a different technique.
Stop losses in Forex are very useful and you should definitely learn how to implement them in your trades. Now, the guaranteed stop loss comes with both strong benefits and visible disadvantages, making this tool not exactly suitable for everyone.
Bottom line is: make sure to properly organize your trading process, whatever risk management technique you choose. It is always better to be safe than sorry, on Forex especially.