Stop losses are fundamental elements in online trading, particularly in Forex. Their purpose is to protect capital and, alternatively, optimize trade performance. Stop losses are "automatic" tools that activate based on the trader's indications. Many inexperienced traders tend to neglect stop losses, which is a mistake, as they can make the difference between a poor performance and a catastrophe. Here's why.
What are stop losses
Technically, stop losses are orders to exit a position. Placing a stop loss means programming the exit from a trade under certain conditions. Generally, this condition coincides with reaching a specific price. As the name suggests, the essential function of a stop loss is to end a losing trade, thus limiting losses. They represent the opposite of take profits, which are exit orders that activate to preserve gains.
While the take profit aims to exit the trade before the market changes direction and starts eroding the hard-earned gains, the stop loss prevents losses from reaching unsustainable levels. A related order type that adjusts as price moves is covered in trailing stop in online trading.
Stop losses and money management
When talking about "unsustainability," it does not indicate an objective element valid for everyone. The thresholds of unsustainability vary from trader to trader and are determined by money management goals and the size of the capital. However, two approaches are useful in determining stop losses.
Using Pivot Points to Set a Stop Loss
In this case, the sustainability threshold is not only given by the trader's tolerance for losses but also by the hopes that the market will reverse the trend and allow the trader to recover what they have lost. If the trend is bearish, it is best to place the stop loss (according to this approach) just below the support, as it is then certain that the market will continue in the bearish phase.
Using Objective Loss Calculations
In this case, the only question the trader must ask is how much loss they can afford. Once this figure is established, it is projected into the trade. The stop loss coincides with the maximum sustainable loss of the trade.
Both approaches are valid. However, the first one is mainly the prerogative of experts as it requires a more marked depth of analysis. Placed poorly, either approach can backfire; see the consequences of misusing a stop loss.
