What is a stop loss or stop loss order to be precise? In this post, you will learn:
- what a stop loss is
- where and how to place a stop loss order when trading
- how to calculate stop loss
- and lot more
What Is A Stop Loss Order?
A stop loss is simply an order to close a trade when price moves against the trade.
And there’s one main reason for doing that: to manage trading risk.
A stop loss order prevent you from losing more in a trade.
Here’s how stop loss order works for a buy and a sell trade situation:
- For a buy trade, a stop loss order will automatically close that trade when price moves down and hits the price level where you want the stop loss order close the trade.
- For a sell trader, a stop loss order will automatically close the trade when price moves up to a price level where the stop loss order was set.
Here’s an example: Joe has a $10,000 trading account and buys 1 standard contract of EURUSD at 1.3500 and places his stop loss 40 pips. The only time Joe’s trade will show negative profit is when price is falling below 1.3500.
For a 1 standard contract, a 40 pips stop loss =$400 risk. (The value of 1 pips for a standard contract =$10). So if price falls to 1.3460, Joe’s trade will be automatically closed out with a $400 loos.
Now, what if Joe did not put a 40 pips stop loss?
What is price fell down 150 pips from the buy price of 1.3500?
Well, that means that next time Joe opens his computer and checks his trade, he will be staring at a paper loss of $1,500! A paper loss is a trading loss that hasn’t be closed yet.
Now, Joe can hope and pray that price will go back up so his loss wills start to decrease or manually close the trade with a real $1500 loss.
Where To Place Stop Loss?
If you are entering a buy trade, stop loss is always placed below the the buy entry price. If price moves up, you will start making profits, but if price moves down, you start making a loss.
Now, if you don’t have a stop loss on a buy trade, the more price moves down, the more your trading losses will increase and you can lose your entire trading account.
Stop Loss Order Example For A Buy Trade
On the chart below, assuming Joe bought GBPNZD as shown:
- the maximum loss Joe can suffer in this trade is if price moves below his buy price and hits the price where his stop loss was placed.
- but on this case, price rose up instead of going down so Joe’s profit increased as price went up.
- but if he never placed a stop loss and price somehow when down instead of up, his loses would increase if there was not stop loss order to get him out of his trade.
Stop Loss Order Example On A Sell Trade
Now, on a sell trade, the situation would be similar but the exact opposite:
- stop loss order is placed above the sell entry price
- the maximum loss that can be suffered in a sell trade is when price moves from the sell entry price and goes up and hits the price where the stop loss is placed.
- if there is not stop loss and price keeps rising, the trading losses will continue to increase.
How To Calculate Stop Loss
The most common type of stop loss is what is called a percentage based stop loss.
A percentage based stop loss is simply allocating a certain percentage of your trading account that you are willing to risk on a trade.
For example, if you have a $10,000 trading account and you are willing to risk 2% in each trade then that equates to risking in dollars, $200 per trade.
Now, having a $200 risk doe not tell you how far away you are going to place your stop loss order on the charts.
- Now in the forex market, stop loss are calculated in Pips.
- You need to calculate how many pips is $200.
- For one standard contract, $200 equates to 20 pips on EURUSD.
- That tells you, that whatever price you buy or sell, you need to place your stop loss order 20 pips away from that entry price and if price goes against your trade by 20 pips, your stop loss order will get hit and you will lose $200.
Can You Trade Without A Stop Loss Order?
Yes, you can.
Is it a good idea? I don’t think so.
I have never traded without a stop loss.
I sleep much better at night knowing that if price goes against my trade, I only suffer what I already predetermined before I placed my trade.