Stop Loss and Take Profit Orders
Stop Loss
As you already know a stop loss order is an order to sell back (if long) when the market hits a predetermined level or to buy back (short) when the market hits the predetermined level.
It works like this: once you have entered a trade you must also set a stop loss order on your trade, if the market hits that level, your stop loss order becomes a market order and your broker sells/buys back the currency pair at that same level to close your position.
The purpose of this order is obvious: to limit the losses of an investor or trader.
However, there is another advantage of using stop loss orders that isn’t that obvious. When we use stop loss orders, we know deep in our minds that the trade has a failure probability. Accepting the fact that all trades have a failure probability eliminates some psychological issues that could have negative effects in our trading performance.
Take for instance, traders that don’t use stop loss orders commonly think their trades are winners before they know the actual outcome of it. If they “know” it is a winner, why should they use a stop loss order? But what happens when the trade goes against them? They will probably average down as the trade goes against them, at some point the loss will be so large and they will be unwilling to take it, hoping the market gives them even the breakeven point.
How many trades where no stop loss is used could wipe out someone’s trading account? Only one.
Acknowledging the fact that every trade has a probable outcome and therefore using stop loss orders is healthier not only for our minds but also for our trading performance.
Stop loss order sceptics will also argue that setting stop loss orders makes you vulnerable to what is called “stop hunting”. Myths where money makers are supposed to “move” the market to where most stop orders are placed, hunting them down. Then the market goes in the intended direction.
But the Forex market is such a big market (over 2 trillion USD traded every day) that it is almost impossible to manipulate. These “wild” moves are just a by-product of imbalances between the demand and supply at important levels; traders tend to act more irrationally or emotionally at these levels (support & resistance, LOPS, HOPS, PP, etc.)
Also, no one knows (but you) where you place your stop loss levels, imagine trying to know where thousands of traders place their stop levels, it would be impossible.
In short, stop loss orders limit our losses on any given trade. It is important to set the stop loss orders whenever you enter a trade because you end up making this important decision when you are most objective (deciding before the trade takes place) about what is happening in the market. If you try to do it when losing a trade, all emotions will kick in making us vulnerable to misjudging current market conditions.
Take Profit Orders
TP orders are also a part of risk management; they are directly correlated to the RR ratio of any given trade. If we lower the TP level it will also lower the RR ratio of that trade (and vice versa).
Setting TP orders also help us create a disciplined approach making possible for traders to walk away from the computer without continuously monitoring the Forex market.
In the next three sections, we will review some methodologies to set SL orders, but they can also be applied to set the TP levels.