What is a Stop Loss Order – how does it work?
Many forex & CFD investors use a little tool called a stop loss order to manage and control their trades.
It’s a great trading risk management tool that can make a big impact.
Keep reading to discover how you could benefit from the tool as well as how to use a stop loss order properly.
Let’s get started!
What is a Stop Loss?
A stop loss is a special tool that will stop you trade pair when it meets a certain price and stops the losses.
For example, let’s say that you buy a CFD share asset for $30, and you place a stop loss order on it for $26. If that share asset goes down in value to $26, the stop loss order would activate automatically and the share asset would be sold.
The asset would be sold as a market order which means that it would be sold quickly at the best price available. It’s an ideal way to exit a trade fast.
Because the stop loss triggers the activation of the sale, it’s a great way for traders to limit their losses on a position.
This makes it an ideal risk management tool for all trading forex tutorials that we’d highly recommend using.
Stop Loss Order Advantages
The main advantage of a stop loss order is that it can minimise your losses, plus it’s a free tool to use. This because many online forex brokers provide the feature for no additional cost to you.
If your broker charges commission on positions, you’ll just be charged your normal commission when the stop loss value has been met and the asset/forex pair sold.
Plus it’s important to remember that the forex & CFD markets are volatile, and as humans we cannot predict how the market will move. No amount of market strategies can predict the exact way the forex & CFD markets will act.
So stop loss orders can help you with this issue by locking in prices when prices are dropping, as well preventing large losses when the markets don’t go in your favour.
Best of all the feature is automatic which means that you don’t have to physically monitor your assets daily.
For instance, if you’re in a situation where you’re away for a few days, you can be reassured that the stop loss will act on your behalf.
- Automatic monitoring
- Form of risk management
- Helps to lock in prices
- Free tool offered by brokers
Downsides of a Stop Loss
Like any tool, there are a few drawbacks to using the stop loss order. You should keep these following points in mind when using it:
Market Fluctuations: Because the forex & CFD market can experience high volatility, a sudden price decrease could activate the stop loss before increasing in price.
Price Certainty: Another downside is that a stop loss does not guarantee you that the sold price will be equal to the stop price.
Remember that when a stop loss is triggered, it will turn into a market order. So if the market is falling rapidly in value, the market order will be sold at the latest price, which may already be below the stop loss order limit. This can lead to a higher loss that you’d expected.
Over reliance: Whilst stop loss orders can monitor your positions on your behalf, it’s good not to be too reliant on the technology. It’s important to remember that the feature will not suddenly make you lots of money when trading.
Instead you’ll need to find the right balance between technology and making your own intelligent investment decisions. That’s the best way to use the tool.
Trailing Stop Loss
Another variation of a stop loss is a trailing stop loss. This does the same job as a stop loss order, but it will also follow the price movement of an asset.
For example, a normal stop loss order is fixed at a certain price level which you have to update manually. A trailing stop loss though, will automatically change its limit level according to the latest price activity
All you need to do when setting up a trailing stop loss order is to state how far below the asset price you require it to trail. This can normally be entered as a total amount, but you can also provide a percentage.
When everything is set up, the price level will be constantly updated every time the asset’s price moves.
The great thing about using a trailing stop order is that it only moves if the asset price moves in your favour. So if the asset price drops, the trailing stop loss limit won’t change.
In the situation that the price stops increasing and starts falling, the distance between the price and the stop loss level will reduce.
The tool acts as a safety net which allows the trailing stop loss level to gain freely, but prevents it from dropping.
If your asset price continues to drop and hits the trailing stop level, then the position will be automatically closed and sold as a market order.
Many leading online forex brokers offer the trailing stop loss order as part of their trading features, and we’d recommend it for use as a risk management tool.
Author of this article and founder of Tradingonlineguide.com
My aim is to help you increase your trading knowledge with helpful content. I come from an economic background and have a strong passion for forex trading. With more than 6 years in the online trading world, I want to share my financial knowledge so that anyone can develop their investment skills.
In my spare time I enjoy cooking and travelling.
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