Take Profit and Stop Loss orders are the most used tools by all traders. More critical of those two is the stop loss order. It gives you protection against unlimited loss, and therefore it is like lifebuoy in cases that market is going against you. But does it gives you full hundred percent protection in all situation? That is the question very important for a successful start to forex trading.
How Stop Loss order really works
In reality, I met many retail and even professional traders who do not know how this order works. They think that by setting stop-loss order, they are adequately protected and know the maximum loss on the position they can incur.
However, they are not.
Firstly, we need to explain how stop-loss order works. Stop-loss order serves to limit your losses. You set a level at which the stop loss should be activated.
When market price reaches that level, your stop loss will be fulfilled at the next tradeable prices below (or above) that level depending on if you have a short or long position.
Normal liquidity situation
1. You opened a long position on EUR/USD at 1.1600 [you bought EUR, sold USD].
2. You want to limit your maximum loss at 100 pips.
3. You set stop loss at 1.1500 level.
4. When the market price reaches 1.1500, your stop-loss order will be fulfilled at the next tradeable price below the level.
5. In the usual situation (with usual liquidity), your order will be realized at 1.1499.
6. Your position was closed at 1.1499 and your loss is 101 pips [1.1600 – 1.1499 = 0,0101 = 101 pips].
Note: If you open a short position, then your stop loss level will be higher than opening price and the order will be filled at pips above the stop loss level.
When the market is as usual, with liquidity at the normal level, the stop-loss order works as everybody thinks. The difference between the stop-loss level and the realized price is negligible.
When market goes crazy
The problem with stop-loss arises when there is something unusual, and the liquidity disappears. At that time next tradeable price can be far away from your stop loss level.
The liquidity disappears more often than you think. The one reason is real market disturbance like the start of war conflict or unusual action of central bank or government.
A very good example is January 15, 2015, and the action of the Swiss National Bank (SNB). After SNB lifted the currency floor on EUR/CHF, the market collapsed from 1.2000 to 0.8700.
At that time, no price existed on the market. Nobody was willing to buy or sell CHF.
Everybody waited and waited, and then after long 30 minutes, the first prices showed up on screens. Prices were 30% below the price before SNB action.
Stop losses were fulfilled at prices almost 30% below stop loss level. That caused many severe losses for banks, and also retail investors.
A lot of traders’ accounts were not just erased but ended the day with negative balances. People got the answer if stop-loss fully protects them in the harshest possible way.
However, the liquidity does not disappear just dramatically, as described above. Sometimes during regular trading, there are quiet periods when spreads are bit wider even on the most liquid currency pairs like EUR/USD.
When the market goes from the New York zone to the Sydney time zone and then to the Tokyo time zone, the liquidity is smaller for short periods. That means that your stop loss can be fulfilled, not pips from your level, but five or seven pips lower.
That does not seem like a big thing, but if you have a significant position or you are close to the margin call, that will hurt a lot.
What alternatives to limit the losses do you have
Traders, who know that stop-loss does not provide 100% protection, are continually looking for alternatives on how to be secure and minimize the risk of losing more. There are two possibilities offered by forex brokers: guaranteed stop-loss orders and using options instead of spot
Guaranteed Stop Loss Order
A lot of forex brokers started to offer guaranteed stop-loss orders after events of 2015. “Guaranteed” means that your stop-loss order will be fulfilled at the level you set up.
That is good news for all traders, but you need to think in a bigger perspective. The losses in 2015 were so cruel that some forex brokers bankrupted.
A lot of retail traders were sued by brokers to cover the negative balances on their accounts. A lot of lawsuits are still alive and waiting for the decision.
That gives you a reason to think about the financial power and stability of your broker. Will it be here even if the market crash happens?
The broker will guarantee all orders of his customers, but will he be able to close the underlying positions on the market? If not, will he have enough reserves to cover the losses staying at his account?
Buying options instead of spot trades is another possibility of how to limit your losses. When you purchase a call or put option, you need to pay a premium.
You pay the premium upfront, and no other payment will ever be required. The premium is the maximum loss you will have in case the market will go the opposite way.
Purchase of options is the smartest way how to trade, speculate, or hedge and do not risk more than you want. Unfortunately, buying options is not very popular among forex traders.
Stop-Loss is your friend
That is an old saying from dealings. However, stop loss is not always a friend. Sometimes it provides a false feeling of security.
The best way how to approach the risks of orders is a full understanding of its mechanism. You need to know their advantages but also disadvantages.
Looking for alternatives in trading always brought a profit. Replacing the spot trading with options purchasing seems like a viable and profitable way how to contain the risks embedded in spot-loss orders.