As the name itself suggests, a stop-loss is a way for you to cut your losses short by placing an order in your trading platform that automatically closes your losing trade once it gets to a certain unbearable level. A counterpart to stop-loss is the "take-profit" order, which functions as a ceiling for further profits. It may sound counter-intuitive, but the reason why a take-profit is applied is to make sure that a trade concludes with a net gain rather than see a wild price swing that slips a position back to negative territory.
But you are probably reading this because you already know what a stop-loss is, and you want to know if there is real evidence that trading Forex without stop-loss is viable or if there is a particular strategy that omits carefully setting automatic stop-orders.
Well, there actually is, and that's discussed in a later paragraph. Still, there are some downsides to that strategy that you should be aware of. We think employing loss curbing measures in trading is still indispensable and should be the chief priority.
In this article, we will tackle mainly the benefits of using stop-loss orders and some reasons why every trade should be equipped with one.
Prevents further losses
A stop-loss is essentially insurance, a safety net if you will, against the further decline of your paper loss. The market's erratic movements are not to be underestimated for even a single trading day could get you the volatility you need to profit immensely.
However, that same volatility, if unchecked, is the main cause of a margin call. Surely, you don't want to see a single trade wipe out your entire trading capital, so a stop-loss saves you from that undesirable scenario.
Involuntary acceptance of a losing trade
When you set a trade with a corresponding stop-loss, you virtually tell yourself to stay calm and let your trade take its course. After all, once you have followed the rules of your strategy to a tee, you understand that all that's left to do is to wait and see how the market reacts.
If the trade doesn't go your way, it's okay, because the stop-order is there to curtail more significant losses. But, this is not the case with inexperienced traders as holding on to losing trades, especially after a riveting winning streak, is an inherent tendency.
Most of the time, your failure to accept a losing trade quickly leads to trading dormancy (i.e., a waiting period for paper loss to overturn, which lasts for weeks, months, or even years). The key is to master forgetfulness, and that means that the only thing that matters is the current trade.
If a trade turns out badly, skip to the next. If it's a good one, ride or take the profit, but never invest too much emotion on past trades.
Know the percentage of loss
Another use of stop-loss is to predetermine risk in percentage terms. If you follow the 1% risk per trade rule, a precise stop level presets that 1% value and you'd know beforehand the amount you risk losing should your trade turn negatively -- even with leverage factored in.
You can also account for the total amount of trades you can take if you know the percentage of your capital that's at risk. For example, a 1% risk per trade allows you to take on 100
trades on your account. Your job, then, is to test and select a strategy that coheres to this risk percentage mathematically.
Take a look at the table below:
A $10,000 account in 10 trades gets more out of a strategy that wins 60% of the time. As the table indicates, a profit of $196.92 or almost 2% is the return for the 60% win rate strategy provided that profit and risk are capped off at 1%.
The 40% win rate strategy works just as well as the 60% with almost a 2% return on the $10,000 too, but this time, the profits are collected at 2% while the same 1% risk is the threshold.
The losing side, however, is with the 30% win rate as it garnered a loss of $108.85.
The conclusion is that a strategy with a 30% win rate is inapt. A proper tweaking of that strategy would perhaps yield a positive return, like setting a 3% target.
None of this predetermination of risk is possible if you don't set a boundary on the charts for stopping losing trades.
Why stop loss doesn't work on investing
A stop-loss can be applied in stock trading as well, and do note that the keyword is trading. If you are investing in a stock, your primary concern is the profitability of the company, and sooner or later, it will reflect on the stock price.
If you overpaid for a stock (purchased it above its intrinsic value), it might take some time for you to see an appreciation of its market price, but only if it's a great business with some room to grow in the future.
And if the market price falls, you have a chance to buy more shares if you are in it for the long run.
But if you need to be in and out of a trade for a few days to a few weeks (especially if you are paying a hefty fee for taking on open positions), using a stop loss will mitigate losses. Because your concern is derived from the stock price and not the actual business, controlling your risk is vital to your profitability.
Risks of stopping the risk
The risk is not erased entirely after a stop-loss order is set. One common drawback of stop-loss orders is a jump in price or slippage.
Slippage happens in periods of very high volatility (usually if there's unexpected news or when the market reacts exaggeratedly to the news) where your orders do not match what your broker has executed.
For example, your stop-loss that was initially set at a 1% risk could close out at a 3% loss.
Trading without a stop-loss strategy
One of the common ways that a trader makes use of a strategy that's devoid of a stop-loss is to place a hedge on the initial position.
For example, instead of placing a stop-loss to a buy order that had gone the opposite way, a trader will instead place a sell order at the supposed-to-be stop-loss level.
But this can be a losing proposition, especially if there's an unanticipated gargantuan move in the market.
On July 15, 2015, when the Swiss franc soared after being unpegged to the Euro, a lot of traders were affected -- even brokers. In fact, the once-mighty FXCM proved that it wasn't infallible to a wild reaction in the market. Traders who skipped setting a stop-loss order on trades that include selling the franc were devastated. Bailouts had to be provided, with some brokers demanding their clients to cough up cash to pay the money owed to them for those who've taken highly levered losing trades.
Still, a trader who used the hedging strategy and bought the EUR/CHF with a pending sell order at 1.1970, but no stop-loss would not have made any money.
Because when the franc rose because of the announcement that day, that sell order would have been triggered, but there's no profit because the buy trade will still be in play. If there's a stop-loss instead of a hedging position, it would have made for a glorious trading day as the franc roughly dwarfed the Euro by 41%.
The lesson and takeaway
Stop-loss is definitely a valuable tool for traders; it limits your losses, predetermines your risk, affords you a mathematically appropriate strategy, and precludes sudden price swings that whack your trading account. But, in the end, you have to know when to quit. It doesn't matter if you use a stop-loss as a safety net in case of an incident similar to the one-day nosedive of the EUR/CHF or as a stopple for losses. What matters is you truncate a lousy trade, wipe off your tears, and move on.
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