Trade ClosureLimit/Stop Order, Stop Loss, Take Profit, Trailing Stop
In Forex trading, the trader can manually open and close trades, or set price levels where trades can be opened or closed automatically. Let’s see what the automatic orders are.
Limit and stop order
Limit and Stop orders are both pending orders with which traders set a future trade opening price along with other parameters like stop loss, take profit, and lot size. Haven input these in a form field, the trade is then sent to the broker's server. If the price of a security reaches a certain level set as stop order or limit order level, the trade is triggered into either a live buy or sell order. Limit orders are the buy limit and sell limit, while the stop is the buy stop and the sell stop.
- A Buy Limit is a pending buy order that is placed at a price lower than the current market price. Orders of this type are usually used when it is assumed that as the current price retrace or movesdown to a certain price often referred to as a support level, price will bounce off this level and commence an upward rise in value i.e. bullish.
- A Sell Limit is a pending sell order that is placed at a price higher than the current market price. Orders of this type are usually used when it is assumed that, as a result of an increase in prices up to a certain price level often referred to as a resistance level, that price will bounce off this level and subsequently commence a decline in value i.e. bearish.
- A Buy Stop is a pending purchase order that is placed at a price higher than the current market price. Orders of this type are usually used in the expectation that price quote, on reaching a certain higher level of price (i.e. resistance), will continue to grow. In other words there will be a further breakthrough of the resistance level (price) establishing new highs.
- A Sell Stop is a pending sell order that is placed at a price lower than the current market price. Orders of this type are usually used because it is assumed that, as market quote reaches a certain level of price (i.e. support), that price will continue to decline. In other words there will be a further breakdown of the support level (price) establishing new lows.
Stop loss is a tool used to safeguard capital invested in a financial asset if the market trend is in the opposite direction to the initial expectations. The purpose of this operation, then, is simply to end a position that tends to lose value.
In practice, it translates into an instant close order on a trade, placedat a pre-set price level without minding the financial position being in loss, thereby reducing the risk exposure on the invested capital. It is one of the input parameters on the form field when entering or modifying a trade and it is automatically initiated as soon as market quote triggers it.
Stop loss as an exit strategy is the most important tool of money management, because good use of it allows forsafeguarding capital. In fact, when a position starts to generate losses, it’s best to close the loss trades before the damage becomes irrecoverable.
There are several theories about a conservative or more risky use of stop loss, which involves placing it close to or far from the order entry price.
- Fixing tight stop losses means that they are more likely to be affected by price fluctuations and therefore we will have many closed trades but with little loss each.
- fixing wide stop loss means less likely that they will be affected by oscillations and therefore we will have few closed trade but with a lot of loss each.
Note: If the same percent risk of capital is applied to atight/narrow stop loss as it is on wide stop loss, a tight stop loss will not necessarily reduce the loss on each trade. In fact the losses on both tight and wide stop loss will be the same using the same percent risk exposure on capital.
It is therefore difficult to establish what the right balance is.
But since one of the most famous laws in trading is to "cut losses short and let the profits run", the wisest thing to do is to fix a stop loss that is always shorter than our take profit i.e. that of our potential profit.
In contrast to stop loss, take profit is a tool to close the trades that have reached the pre-set profit.
In practice, it results in a closing order sent to the market, at a pre-set price level, aimed at closing the financial position in profit. It is one of the input parameters on the form field when entering or modifying a trade and it is automatically initiated as soon as market quote triggers it.
The logic of using take profits depends on the type of trading logic you want to deal with. In many cases, it is also based on potential rebound points i.e. support or resistance levels, to avoid a reverse of the accumulated profit so far.
Also, as already indicated, it would be good to have a fair proportion between take profit and stop loss. In most common uses the take profit length is double the length of the stop loss, often referred to as a risk to reward ratio of 2:1.
The trailing stop is a stop loss variant that is not static, but dynamic. In fact, the price of the stop loss varies as the price moves, and is adjusted according to a percentage of the maximum profit achieved.
For example, if a Trailing Stop Loss is set to 5%, if you buy a position, we set it to 1,000, the stop loss will be set at a price of 0.950 (that is, a maximum loss of 5% of its initial value). If during the trade the asset rises up to 1.200, its stop loss is moved to 1.140. A possible increase in the price would keep the stop loss at the most recent level, but a possible price decrease would not make it move further, but would remain firm until it is hit.
In practice this technique tends to let the profit run, trying to close the trade only when there is a price reversal.
With a trailing stop in place it is sometimes possible to have a trade close in profit with the stop loss, thereby locking in the profits made above the trade entry point.
the Analyst's answerJean Grossett - Financial analyst
Understanding Entry and Exit strategy is very important when building a trading strategy. Of the two, exit strategy is the most important since it involves managing risk. Instant, stop, and limit orders are entry strategy variants, while the stop loss and trailing stop are exit strategy orders. Most times traders know how to get into a trade, but do not know where to set their stop loss order.
In order to set a stop loss, it is important to identify strong market support or resistant levels that are related to our current entry point. In a case of a buy order, placing a stop loss a couple of pips bellow a critical support level is useful. If a time-frame bar in which the order was placed close below this support before hitting your set stop loss level, it is wise to carry out an instant close of the order, following the phrase “Cut your losses short. The opposite of this applies to when a sell order is placed.
the Manager's answerRobert Danvil - Investment Manager
Advice for using take profit and stop loss. Using tight stop loss in trading without researching the underlying strategy on history data can be a very risky venture, considering that markets often experience spikes, whip saw and whip lashes that could trigger the stop loss or trailed stop order, only to immediately resume in the initial direction. Analyzing a trading strategy’s maximum adverse excursion (MAE) and maximum favorable excursion (MFE) can help in placing stop loss orders and take profits.
Tight stop losses used on a standard account will definitely reduce loss compared to wider stop loss on the same account type and lot size. However when we look at risk from a percentage point of view, there is no difference between a tight stop and a wide stop, since the similar percentage exposed on a standard account for a particular high time frame, can be implemented on a micro or cent account on the same high time-frame