Understanding the different types of orders in forex trading is essential for effective risk management and successful trading.
Stop-loss orders are critically important, as they help traders limit any potential losses by automatically closing a trade at a pre-determined price level.
This article explains the different types of forex stop-loss orders and provides a detailed guide on setting and using stop-loss orders for both retail and prop traders.
What are stop-loss orders?
Stop-loss orders are an essential tool for managing risk in forex trading.
They are orders entered into your trading platform which automatically closes the trade when a defined loss has been realised.
The order automatically closes the trade at either a set price, or when the currency pair reaches a pre-determined level, thereby limiting potential losses.
Understanding how stop-loss orders work and how to use them effectively is crucial for any trader aiming to minimise their risk and maximise their profitability.
The stop-loss position depends on the trade direction
The position of your stop-loss will either be above or below the current price action:
- If you enter a long position, your stop loss will be below the price at which you enter the trade
- If you enter a short position, your stop loss will be above the price at which you enter the trade
Different types of stop-loss orders
There are two different types of stop-loss orders:
- A ‘fixed’ stop-loss order
- A ‘trailing’ stop-loss order
Fixed stop-loss orders
This is the most common type of stop-loss order. It is a simple instruction to close a trade at a specified price level.
When the market price reaches this level, the trade is executed automatically.
The order will remain in place until it is either triggered or cancelled, or you close the trade yourself at another price point.
For example, if you’re trading USD/JPY, you may decide to enter a long trade at 161.40, and set your stop-loss at 161.30, or 10-pips below your entry price.
A fixed stop-loss order would automatically close your trade if the price dropped to 161.30.
It is irrelevant how long the price stays at this set point, or if it recovers once hitting 161.30.
A fixed stop-loss set at 161.30 will exit you from the trade at the nearest available market price as soon as the price hits the specified stop-loss value.
Trailing stop-loss orders
A trailing stop-loss order allows the stop-loss to move with the market price, staying a set distance either above or below the market price, depending on whether your trade is a long or short trade.
This means if the market price moves in your favour, the stop-loss level adjusts itself accordingly, locking in your profits.
However, if the market price then changes direction and moves against you, the stop-loss level remains unchanged, protecting you from significant losses.
Trailing stop-loss orders can be set several different ways. For example:
- a defined dollar amount of loss (eg. $100 loss)
- a specified number of pips above or below current price action (eg. 15-pips from current price action)
The advantage that trailing stop-loss orders have over fixed stop-loss orders is that if the market moves in your favour, the stop-loss will also move, potentially locking in your profit.
However, once a stop-loss moves up or down closer to price action, it will not reverse direction, and so will be triggered if price action does suddenly reverse.
The diagram below shows how a trailing stop-loss moves with price action on a long trade:
This is how a trailing stop-loss will protect your profits on a short trade:
The benefits of stop-loss orders
1. Risk management
Stop-loss orders help traders manage their risk by limiting potential losses on a trade. This is especially important in volatile forex markets where prices can change rapidly.
They are a safety net to limit your losses, and should always be used when setting up your trade as part of your risk-reward calculation.
2. Emotional discipline
By setting a stop-loss order, traders can avoid making impulsive decisions driven by fear or greed.
The stop-loss order ensures that trades are closed at a pre-determined level, maintaining a disciplined approach to trading.
Stop-loss orders should always form part of your rules-based trading plan, ensuring you never risk more than your trading plan allows for.
3. Automation
Stop-loss orders automate the process of closing trades, allowing traders to focus on other aspects of their trading strategy.
This is particularly useful for those traders who are unable to constantly monitor the market, ensuring an automatic safety net is in place if losses reach a pre-defined level.
Now that we’ve looked at the different types of stop-loss orders available, we’ll dive deeper and look at different ways to implement stop-loss orders.
Different ways to set stop-loss orders
Setting a fixed stop-loss based on a dollar loss amount
This method involves determining the maximum amount of money you are willing to lose on a trade, and setting the stop-loss accordingly.
For example: You buy USD/JPY at 162.00 and are willing to risk $100 on the trade.
If your trade size is 10,000 units, and each pip is worth approximately $0.91, you can set your stop-loss at 160.90 (which is 162.00 minus 110 pips).
This would ensure that if your stop-loss was hit, the loss you will experience will only amount to a maximum of $100.
Setting a trailing stop-loss based on a set number of pips
Setting a stop-loss based on a set number pips involves determining the number of pips you are willing to lose, and then placing the trailing stop-loss at that distance from your entry price.
For example: You buy USD/JPY long at 162.00 and decide to set a trailing stop-loss 10-pips below your entry price.
If the price rises to 162.50, your trailing stop-loss will rise to 162.40, always trailing 10-pips below price action.
However, if the price then falls to 162.39, your stop-loss would be triggered as soon as the price fell to 162.40, protecting your 40-pip profit.
The advantage of setting a trailing stop based on a number of pips is that it will protect your profit if the price goes in your favour, but will keep your loss to a known set amount.
Setting a stop-loss at an actual price level
This method involves placing the stop-loss at a specific price level based on technical analysis, an indicator, or support and resistance levels.
(We’ll explore different stop-loss strategy options later in this article.)
For example: You buy USD/JPY at 161.00, and technical analysis indicates strong support at 160.00.
You could decide to set your fixed stop-loss just below this level at 159.97 to protect your trade.
If the stop was triggered, this would mean you would lose 103 pips.
The disadvantage of this option is that although it limits your losses, it doesn’t automatically protect your profit.
In the case above, if you had bought at 161.00, and the price rose to 161.80, then you would have a nice 80-pip profit.
However, if the price then fell again before you exited the trade, and hit your stop-loss, you would end up with the same 103-pip loss, despite previously being in profit.
This is where a trailing stop-loss which moves with price action is often preferable to a fixed stop-loss.
Strategies for setting your stop-loss position
Now you know the various types of stop-loss orders that are available, it’s time to think about strategies for using these various orders.
In MarketMates’ Advanced Forex Course for Smart Traders 2.0, my colleague Sam talks about three different ways to determine your stop-loss point for a trade:
- using a fixed-pip stop-loss placement method as standard for every trade
- basing your stop-loss on the Average True Range (ATR) of the asset being traded
- using technical analysis (looking at chart patterns, or support and resistance levels) to determine where to place your stop-loss order
Using a fixed-pip stop-loss method
This method involves deciding how much you are prepared to risk losing on a trade, based on a set number of pips.
Based on your risk tolerance and trading plan, you may decide you are prepared to risk between 10-pips and 30-pips if your trading style involves taking relatively short trades.
If you decide on a longer trading strategy, perhaps weeks or months, your pip-based stop-loss may be a higher number, up to 80 or 100-pips.
If you decide on this strategy, you can automatically set a trailing stop-loss based on that set number of pips.
Once a loss involving your specified number of pips is registered, your trade will automatically be closed out.
The disadvantage of this strategy is that not all pips are worth the same, depending on the currency you are trading.
Therefore, this system does not work well across different currency pairs, as 10-pips on GBP/JPY is very different to 10-pips on AUD/USD (because of the different values of the currency pairs.)
ATR-based stop-loss points
The Average True Range (ATR) is an indicator that shows a trader the average amount that the price of a forex pair has moved up and down in a specific time period.
For example, a five-day ATR will show average price action over a five-day period.
Here’s an example of what the ATR indicator looks like on a trading chart, viewed in a separate chart below candlestick price action with Bollinger Bands displayed:
The ATR indicator will show you in pips how much, on average, the price of the pair has moved in the period you specify.
You can then use this pip number to make a decision about how many pips away from your entry to base your stop-loss.
For example, the famous ‘Turtle Traders’ were told to use a 2 x ATR stop-loss when they were trading.
This would mean if your ATR is seven, then you would place your stop loss 2 x 7 = 14-pips from your entry.
The advantage of basing your stop-loss on the ATR is that it takes market volatility into consideration.
It is not a ‘one-size-fits-all’ method, but rather is sensitive and appropriate for the current price action of the pair you are trading.
If market action is quiet, with very little price movement, the ATR will be a lower number, which reflects the current market type.
However, if there is extreme price movement in a volatile market, the ATR will reflect this and so will be higher.
Therefore, using ATR as the basis for your stop-loss takes the current market condition into account, and so is highly relevant to your immediate trading period.
Using technical analysis to set your stop-loss point
Another method to determine your stop-loss level is to use a variety of technical analysis methods to determine an appropriate place to set your stop.
Technical analysis methods you can use to determine your stop-loss point include:
- known support or resistance levels
- candlestick patterns
- a variety of chart indicators
Using support and resistance levels to determine stop-loss
Support and resistance levels are known price points beyond which the price of the pair doesn’t tend to move within one trend.
If price action falls, a support level will act as a ‘floor’ or minimum price limit, at which point bulls will come in and push the price higher. This is known as being ‘oversold.’
Similarly, a resistance level is a point at which the market considers the price too high, a ceiling on the price if you like.
At this level the bears will move in and the price will retreat. This is known as being ‘overbought.’
If you’d like to understand more about support and resistance, you can read more about the meaning of overbought and oversold here.
Using known support and resistance levels is a reliable and relevant method to determine where to place your stop-loss point.
The diagram below shows how price action often respects support and resistance lines, and so these levels are a reliable guide to where to place a stop-loss level.
From personal experience, I’ve found that these support and resistance levels are often used by the ‘big boys’ ie. professional traders, so it can be worth setting your stop-loss just a few pips above support or below resistance to avoid being stopped out unnecessarily.
For example, if you are trading USD/JPY, and there is strong resistance at 160.00, place your stop at 160.02 or 160.03 so you don’t get stopped out when the price reverses at exactly 160.00.
Using candlestick patterns to determine stop-loss points
Candlesticks can also serve as useful pointers as to where to place your stop-loss.
For example, if you have observed a downtrend, and the price has then reversed, you may decide to place your stop-loss at the top of the lowest candlestick of the downtrend before the reversal happened.
Alternatively, if you see an uptrend faltering, and decide to go for a short trade, you could choose the high point of the highest candlestick as your stop-loss to minimise risk on your short trade.
Here’s an example of how to set your stop-loss based on the candlesticks in a downtrend:
Using indicators to set your stop-loss
As mentioned above, there’s a variety of indicators you can use to help you determine where to place your stop-loss.
These include:
- Bollinger Bands
- the Parabolic SAR indicator
- the Supertrend indicator
Here’s an example of how to use Bollinger Bands to set a stop-loss on a short trade:
The Parabolic SAR (Stop And Reverse) indicator is also useful for determining a stop-loss position.
This indicator creates a dotted line either above or below the price action.
When the dotted line switches from below to above price action, or the reverse, it means a price reversal has taken place.
Here’s an example of the Parabolic SAR in both an uptrend and a downtrend:
The Supertrend indicator can also be used to set trailing stop-loss levels, as it gives a clear indication of high and low price action in both up and downtrends, as shown here:
Final thoughts
Understanding and effectively using different types of stop-loss orders is crucial for managing risk and protecting your trading capital.
Both Sam and I are keen on using trailing stop-loss orders to effectively manage risk and protect our profit at the same time.
By setting a trailing stop-loss order based on a dollar amount, pips, or an actual price point, you can effectively protect your investment and minimise any potential losses.
At the end of the day, it doesn’t matter which method you use to determine your stop-loss point.
Whether you base your stop-loss on an indicator, on the ATR, or on candlesticks won’t affect your trading profitability overall.
What IS really important is that:
- you always use an automatic stop-loss order, for every single trade you place, without fail
- your stop-loss position is placed according to your trading plan, which will take your risk profile and trading objectives into account
- your stop-loss position is reviewed regularly to ensure it is still appropriate for the current market condition and price action
Mastering where to place your stop-loss order as part of a rules-based trading system will set you up for success and help you in your journey to become a confident and consistent forex trader.
Till next time, happy trading!
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Sources
Marketmates uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial guidelines to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
- Bollinger Bands – John Bollinger https://www.bollingerbands.com/
- Louise Bedford – The Secret of Candlestick Charting https://www.tradinggame.com.au/product/technical-analysis/the-secret-of-candlestick-charting
- J. Welles Wilder Jr – inventor of the ATR indicator in his book New Concepts in Technical Trading Systems https://www.amazon.com.au/New-Concepts-Technical-Trading-Systems/
