Managing Trading Risk Using Stop Loss
Why Set a Stop Loss?
If you would like to know how to be a forex trader then the first thing you must know is that forex products are typically traded on margin accounts with large amounts of leverage, usually anywhere from 50:1 to 200:1 and sometimes as high as 500:1.
Leverage can be a great tool allowing the use of a relatively small amount of money in order to profit from the fluctuating value of a large amount of money. This also can work against you as the fluctuating value of a large amount of money can cause you to lose the entire relatively small amount of money.
This relatively small amount of money is your capital that is deposited with the broker and may not actually be a small amount of money. This is why you must use proper risk management techniques when trading to protect your capital. The most basic of risk management techniques is using the forex stop loss order. This assigns a limit to the amount of loss that can be taken on an individual trade, but how much loss is acceptable?
Acceptable loss is relative to many things but a good place to start is to look at the actual value of 1 unit of loss. Profits and losses are measured in units called PIPs which are referenced from the fourth decimal place in most quotes. For example, if you were to buy EURUSD for 1.3471 and sell it for 1.3465 then you would have taken a loss of 6 pips. Forex products are sold in quantities of lots.
A standard lot or 1.0 lot is for 100,000 units, a mini lot or 0.1 lot is for 10,000 units and a micro lot or 0.01 lot is for 1,000 units. The actual value of each pip is relative to the size of the lot you have ordered. Using EURUSD 1.3471, to buy a standard lot or 1.0 lot you would need to pay 1.3471USD * 100,000 units for a total of $134,710USD for 100,000EUR before applying leverage. Since a pip is measured as 0.0001, the following calculation can be made ((.0001 / 1.3471) * 100,000) which gives a pip value of 7.4234EUR.
In USD this would be 7.4234EUR * 1.3471 (exchange rate) and give USD10 per pip. Pip values in USD can simply be stated as being $10 for a standard lot or 1.0 lot of 100,000 units, $1 for a mini lot or 0.1 lot of 10,000 units, and $0.10 for a micro lot or 0.01 lot of 1,000 units. So for the example of a 6 pip loss, if you have traded with a standard lot then your loss would be $60 or with a mini lot you would have lost $6 and a loss of $0.60 with a micro lot.
Give Loss a Value
Now that you know how much to expect for a unit of loss, you can give the maximum allowable loss a value based on how much capital you have to invest. A good value for a beginner to start with is 2% of your total capital for any one trade. This means that if you have $1000 to invest then a 2% loss would equate to $20.
If you were to go with a standard lot which has a pip value of $10USD then you could only lose 2 pips before maximum loss. You need to allow for some loss without closing your position with your stop loss right away so a standard lot would be too large for your capital level. A good starting point is to allow a loss of 50 pips before your forex stop loss order is triggered.
A mini lot with a pip value of $1USD is getting closer as it would allow for 20 pips before your maximum loss is reached, but still not ideal for a beginner. A micro lot comes with a pip value of $0.10USD allowing 200 pips loss before maximum allowable loss is reached. If we take 200 pips and divide by 4 the result is 50 pips so now take the 0.01 lot and multiply by 4 to get 0.04 which tells us that 0.04 lots or 4 x 0.01(micro lot) is a good amount to order with a stop loss of 50 pips.
Just remember to stick with currency pairs that have enough active trades so that your stop loss order can be filled when it is triggered. If the broker cannot fill your order due to lack of trading volume on the currency pair then losses may continue beyond your maximum allowable amount until the order can be filled. Staying with the major currency pairs will eliminate this possible problem. The majors are EURUSD, USDJPY, GBPUSD, AUDUSD, USDCHF, and USDCAD.
Trailing Stop Loss
If you are looking for forex trading strategies that work, try an advanced technique used with a stop loss order called trailing stop loss. This gives you the ability to reduce or eliminate the possibility of any loss by moving your stop loss amount with the increasing profit of your order. Once your pair has a profit of 50 pips you can move your 50 pip stop loss amount to your purchase price or break even point so the worse you can do is break even on your trade.
You can take this one step further and continue to follow the increasing value of your trade and guarantee profits. Your trading terminal will most likely offer this as an automated feature. This is a one way strategy and you should never change your stop loss value in the negative direction in the hope that your trade will recover if it only had a few extra pips of loss to work with. Setting a stop loss on order sizes that work with your level of capital will save you from losing all the money you have built with profitable trades on one big loss.
Don’t be greedy, try to keep emotion out of the equation, never invest money that you cannot afford to lose and you will be one step closer to trading forex for a living on a beach somewhere that has Wi-Fi.
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