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- What is Stop Loss Order
Stop Loss Order - Limit and Stop Orders Explained
Forex trading is practically implemented via several orders a trader specifies for his trading account to be executed. There are several types of orders suitable for different trading strategies aimed to take advantage of different expected asset price movements. Stop loss orders help to limit the loss from asset price movement in the direction opposite from what the trader expected.
A trader can use profit and loss calculator to see at what price a position that gets opened results in the maximum loss he is willing to take, and enter a stop loss order at that price. That stop loss order then will automatically close an opened position if price moves against expectations and reaches that level.
KEY TAKEAWAYS
- Forex trading involves risk and one of main ways to limit risk exposure for a trade is using stop loss orders.
- Stop-loss order gets activated when asset price crosses a specified level as price moves against the executed trade.
- A stop-loss order is used by traders to limit losses and reduce risk exposure.
- A limit order is an order with a restriction on the maximum price to be paid (with a buy limit) or the minimum price to be received (with a sell limit).
What is Stop Loss Order
Stop-loss order gets activated when asset price crosses a specified level as price moves against the executed trade. Its purpose is to limit the loss from an executed trade when the price moves in opposite direction from what the trade expectations were based upon. Stop loss orders are used in trading any asset including forex trading. Professional traders rarely enter trade orders in any market without specifying stop loss orders for them.
Advantages of the Stop Loss Order
A stop-loss order is used by traders to limit losses and reduce risk exposure. The main advantage of stop loss order is that it makes possible to limit the risk in a trade to a set amount in case when the market moves against the trade.
Essentially it is an order to exit a trading position after entering the latter if the price of the asset moves against the trade creating a specified amount of loss in the trade.
For example, a trader who buys one lot (100,000 units) of EURUSD couple at 1.0990 exchange rate may enter a stop-loss order to sell euros, closing out the trade, at 1.0980. It effectively limits his risk on the trade to a maximum loss of $100. If the price falls to 1.0980, the order will automatically be executed, closing out the trade. Stop-loss orders can be particularly helpful in the event of an unexpected and steep price movement against a trader’s position.
Stop-loss orders can be used also to lock in a certain amount of profit in a trade. For example, if a trader has bought a stock at $45 a share and the price subsequently rises to $49 a share, he might place a stop-loss order at $48 a share, locking in a $3 per share profit in the event that the price of the stock falls back down to $48 a share.
Disadvantages of the Stop Loss Order
It is important to understand that a stop-loss order does not guarantee closing of a trade exactly at the price specified. When the price level of a security moves to – or beyond – the specified stop-loss order price, the stop-loss order immediately becomes a market order to buy or sell at the best available price.
Therefore, a stop-loss order may not be filled at exactly the specified stop price level. It will usually be filled close to the specified stop price. But traders should be aware that in instances of high market volatility stop-loss orders may not provide expected protection.
For example, let’s say a trader has purchased a stock at $40 per share and placed a stop-loss order at $35 a share, and that the stock closes on one trading day at $42 a share. Then, after the close of trading for the day, extremely negative news about the company comes out.
If the stock price gaps lower on the market open the next trading day – say, with trading opening at $20 a share – then the trader’s $35 a share stop-loss order will immediately be triggered because the price has fallen to below the stop-loss order price, but it will not be filled anywhere close to $35 a share. Instead, it will be filled around the prevailing market price of $20 per share.
What is a Limit Order
A limit order is an order with a restriction on the maximum price to be paid (with a buy limit) or the minimum price to be received (with a sell limit). If the order is filled, it will only be at the specified limit price or better. In case the price fails to reach the specified value - no execution would occur.
However, there is no guarantee of execution for limit orders. They are generally executed on a first come, first served basis. Even if the asset price reached the specified limit price value, the order may not be filled, because there may be orders ahead of it. In that case, there may not be enough or additional sellers willing to sell at that limit price, so the order wouldn't be filled.
How to Use Limit Orders
All trading platforms allow entering limit orders. So one can download Metatrader 4 or Metatrader 5, open the Chart Window for the currency pair or asset he wants to trade and study the price chart.
Let us say the Chart Window for a stock shows the stock is trading at $45 and the trend is bullish. You want to buy it but expect the price will retrace lower and then resume advancing. It makes a perfect sense to place a limit buy order – say you expect it will go below $35, then you would place a buy limit order with a limit price of $35.
If the stock fell to that level or lower, the limit order would be triggered and the order would be executed at $35 or below. If the stock failed to fall to $35 or below, no execution would occur.
In case you wanted to sell the stock when it reached $55 - you would place a sell limit order with a limit price of $55. If the stock rose to that level or higher, the limit order would be triggered and the order would be executed at $55 or above. If the stock failed to rise to $55 or above, no execution would occur.
Bottom Line on Stop Loss Order
Stop-loss order helps to limit the loss which can result from asset price movement in the direction opposite to what trader expected. While it does not guarantee that the loss incurred will not exceed a specified amount under high volatility market conditions, it is one of main tools for limiting risk exposure.
