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What is Stop Loss in Trading?

Summary

Trading guide on Stop Loss for beginners with explanations, examples, and screenshots.

 

A lot of Forex beginners encounter the term stop loss, but few understand what it means. In this article, we will take a look at the essence and details of what stop loss is. We will also learn how to install stop loss to increase trade efficiency.

What is Stop Loss and Why Do You Need to Use it?

Stop loss is a pending order to close a position, which is activated if the losses in the transaction reach a certain point. To put it simply, stop loss provides protection against large losses in trading.

So, how does it work?

  1. A trader opens an EUR/USD deal to buy at a price of 1.2000
  2. In case the transaction expectations are erroneous and the price goes down, the trader sets a stop loss at 1.1990
  3. If the price rises, as the trader initially intended, the transaction is closed with a profit, and the stop loss is untapped
  4. If the price drops and reaches the level of 1.1990, the transaction will automatically close, and the trader will fix a loss of 10 pips, avoiding large losses.

I1 An example of stop loss in a buy deal on EUR/USD.

How to Set a Stop Loss in the MT4 Trading Platform

You can set a stop loss in the MT4 trading platform in just a few seconds. There are two ways to set a stop loss order:

  1. The classic way, which has been around since the beginning of the platform; or
  2. The quick way, which was added after the global update of MT4 in 2013.

The classic way to set a stop loss is:

  1. You need to open a window for creating a new deal, which can be done by right-clicking on the chart window with the asset and selecting «Trading – New Order».
  2. In the window that opens, you need to set all the necessary parameters (the opening price of the transaction, volume, and type) and the level of stop loss.
  3. When a deal is open, or a pending order is placed, the stop loss will be automatically set at the specified level.

I4 Setting a stop loss through the New Order window

Similarly, you can set a stop loss for a transaction that’s already open. Just right-click on a line with an open transaction and select «Modify or Delete Order», and the same window will open. In this window, you can set up a stop loss or make changes to previous ones.

The quick way to set a stop loss is:

  1. You need to open a deal or place a pending order.
  2. Click the left mouse button on the order line in the chart and drag it down (if the deal opens for a purchase) or up (if the deal opens for a sale).

The downside of setting a stop loss the quick way is that it is not always possible to set it to a precise limit. However, you can save a few seconds, which is very important for scalp trading.

Types of Stop Losses

There are two types of stop losses in most modern trading terminals: standard and self-modifying. Let’s consider each category in more detail.

Standard Stop Loss

Standard stop loss is the stop limit set by a trader, which remains unchanged. Stop loss will close if the price reaches its level, or the trader can personally change or remove it if they want.

Standard stop losses are divided into two subtypes:

  1. Base stop loss – the most popular type of stop loss works on the principle of “closing at the real price.” This means that a broker closes the deal as soon as the stop loss is touched. If there is high volatility in the market, and the price “flies” the stop loss level and goes further, then a broker will still close the deal, but the trader may lose an extra few pips. This situation is also called “slippage”.
  2. Guaranteed stop loss – differs from the basic one in that the broker undertakes to close the transaction at the specified price, even in a situation where the real market price has already overcome this level. That means that the broker takes the risk of volatility.

For a trader, guaranteed stop loss is more profitable, but not every broker offers such terms of trade. Also, a broker can increase the spreads or assign an additional commission.

Self-modifying stop loss

A self-modifying stop loss, or trailing stop, is a stop order that follows the price, protecting the profit. If the trader’s predictions are correct, the trailing stop moves after the price at a specified distance. If the price turns against the trader’s position, the trailing stop acts as a normal stop loss up to the closing of the transaction.

I2 Setting a trailing stop

Trailing stops are set slightly differently than a standard stop loss. After the opening of the transaction, you need to click on its order line with the right mouse button and select «Trailing Stop». Then you can set a stop indent from the price.

Stop Loss Strategies

There are several basic working methods for setting a stop loss. The conditions for placing stops are specified separately in most trading systems.

Stop loss schedule

Scheduling is the most common way to work with stop loss when the trading system does not stipulate any specific rules of operation. When a trader sets a stop on a schedule, attention is paid to the following factors:

  1. Key levels – a stop loss can be set by support/resistance levels.
  2. Local minima and maxima.
  3. Candle highs and lows.

I3 Stop loss on the support level

Always remember that when opening a buy transaction, the stop loss is set slightly below the support level or local minimum, and when selling it, it is set just above the resistance level or local maximum.

The Percent Stop Loss

Interest stop loss is usually tied to a constant value, for example, the capital of a trader. There is a classic rule that losses in one transaction should not exceed 2% of overall capital.

The percentage of a stop loss can be calculated as follows:

  1. A trader has $100,000 in capital.
  2. This means the maximum loss in a single transaction can be $2,000.
  3. When you open a transaction of 10 lots in EUR/USD, 1 pip will be equal to $100.
  4. $2000 = 20 pips, so the stop loss should be set at that distance from the opening price of the transaction.

Stop Loss by Time

Stop loss by time is an exit from the transaction at a certain point, regardless of the results of the trade. Such an exit is not exactly a stop loss, as the trader closes the deal manually, but many experts attribute it to the category of stops. A good example of stop loss by time is closing deals at the end of the day for intraday trading. This style of trading does not allow trades to be left open for the next day, so, regardless of the result, the trader should close them at the end of the day.

Conclusion

There are different types of stop losses and different tactics for their use. However, one tenet holds true for all Forex strategies: trading without a stop loss is a mistake. Stop losses must be set, especially for beginner traders, as it will ensure your capital is protected and make the trade more meaningful and systemic.

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