Whereas market orders and entry orders are trade entries, stop losses, trailing stops, and profi t limits (described in the next section) are trade exits. While many beginning traders concentrate almost exclusively on entries, most intermediate and advanced traders eventually come to realize that exits are at least as important, and some say even more important, than getting the entries right.
In this section, only the basic mechanics of stop losses and trailing stops will be touched upon. Later, in Chapter 6 , in a section that covers risk management, the full meaning and nuances of using stop losses will be discussed.
Stop losses are exactly what they appear to be. They actually “ stop losses. ” A stop loss is a form of pending order that can be attached to any open order or position, whether that trade was originally a market order or an entry order.
A stop loss closes an open trade when that trade reaches a predetermined level of loss. It is the price point at which a trader no longer wishes to be involved in the trade because of the desire to limit losses to a manageable level.
When using technical analysis (which will be discussed in great detail in Chapter 3 ), a trader will employ a stop loss to get out of a losing trade once that trade no longer makes sense from a technical price perspective.
For example, if a currency pair ’ s price breaks out above a critical resistance line, and a technical trader then buys the pair in hopes of profi ting on a continued price climb, a sensible location for a technical stop loss would be right below the line from where price broke out. This is because if price subsequently retreats back below the line, it is no longer considered a valid breakout trade and the trade no longer makes sense. Stop losses are an incredibly useful tool for predetermining trade risk and limiting catastrophic trading losses.
The close cousin to the simple stop loss is the trailing stop loss. Whereas a stop loss is, by defi nition, a static order to close a trade at a predetermined loss level, a trailing stop loss is a dynamic order to close a trade at progressively better prices. The primary purpose of a trailing stop loss order is to limit losses while automatically locking in gains. A trailing stop loss accomplishes this by systematically moving the stop loss as the price moves in favor of the position.
For example, a trader buys the EUR/USD pair. The trader then wishes not only to limit losses if price goes against this long position, but also to lock - in gains if price favors the position. To accomplish this, the trader would set - up a trailing stop loss. If the stop - loss is set to trail the market price by 20 pips (the concept of pips will be described shortly), it will actually follow the price dynamically by an increment of 20 pips as the market moves, but only if the market moves in a favorable direction.
The key concept to remember is that the trailing stop will only move one way — in favor of the trader ’ s position. If price moves against the trader ’ s position, the trailing stop will not move. And if price moves against the trader ’ s position by more than the predetermined trailing stop increment, the trade will automatically be closed by the trailing stop. If this occurs after a long price run in favor of the trader ’ s position, substantial profi ts will have been gained while having dynamically limited losses from the outset.
Trailing stop losses are often key components of professional risk management strategies, and can be used to great advantage by the typical foreign exchange trader.
