Stop losses and take profit levels are used by forex traders to protect them from unnecessary financial risk and also to ensure that profits are taken for successful trades. Stop losses and take profit levels are both orders which are placed in the market to close an open position. Traders following a particular strategy are likely to nominate their stop-loss and take-profit level at the same time as they enter the trade. Both of these type of orders form part of a traders’ risk management strategy and ensure solid money management in controlling total potential loss and gain for each trade. Whilst stop losses are employed by almost all forex traders, take profit levels may be seen as less essential, although they remove many of the problems faced by traders holding winning positions.
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The importance of stop loss and take profit orders
Stop losses and take profit levels are important in helping to remove the necessity to make emotional decisions during real-time trading. The psychology of trading suggests that markets are controlled by fear and greed. Whilst different traders will express different levels of how much they are willing to lose or gain from a trade, stop losses and take profit levels allow this to be mechanised. This means that winning trades are less likely to turn in to losing positions and unsuccessful trades will not result in catastrophic losses. Stop losses are also important due to volatility that can occur in forex markets with sudden and unpredictable news and events which can cause large moves and cause heavy losses. Although regular stop loss orders are not guaranteed, and can therefore be exposed to similar slippage in fast-moving markets, it is possible to guarantee stops with many brokers which can defend traders against these moves.
Stop loss levels should be calculated during the preparation of the trade as they form an essential part of a trader’s money and risk management strategy, their calculation should rely on two factors. The first of these is how much risk they will expose the trading account to during each trade. Ideally, this should be limited to 2% of the account value as an absolute maximum. The second factor is for the stop loss to be relative to the potential gains and therefore the take profit level. Ideally, the risk of losses on each trade should not be greater than the potential profits.
Technical stop losses
Some experienced forex traders prefer to use technical stop loss levels in order to protect their accounts. These stop loss levels favour swing traders who hold longer term positions and require that the trade has a reasonable amount of space to ‘breathe’. The reason why these stops are technical is that they are usually placed at levels which would show that the trade has failed should they be triggered. Amongst others, this could be above or below a key support or resistance level, pivot level or identified Elliot wave within a price chart. Even though technical stop losses may offer more flexibility to forex traders, they are generally only employed where the potential profit is anticipated to far exceed the loss that these stop losses represent.
When a stop loss can be moved
Although it is considered unwise to get in to the habit of extending stop losses once the trade is active and as the price moves closer to the original level, most traders enjoy moving their stop loss to break-even once the trade moves in to profit. By moving the stop loss to the entry price, a trade becomes almost entirely risk-free and allows the trader to focus entirely on the profit level that they require. Employing a take profit order once the stop loss is at break even will assist with the difficulties of knowing when to close the trade.
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