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Not setting trading stops is one of the biggest mistakes a forex trader can make. The reason most traders fail to set stops is simple - it assumes that trades can fail. A good trading system can result in successful trades a majority of the time, but never 100% of the time. You have to practice risk management to ensure that you don't lose too much when trades turn against you and trading stops are essential to this. Otherwise, your losses could easily be greater than your gains. There are two approaches to setting stops.
Static Stop
Under this approach, the take-profit and stop-loss orders are set at a static price and will not move until the trade reaches the stop or limit price levels. To illustrate how this works, let's say you want to make trades with a reward-to-risk ratio of 1:1, that is, for every 100 pips that you risk, you expect to earn a maximum 100 pips.
You can also base your stops on a market indicator such as the Average True Range or ATR. The ATR is an indicator that measures volatility and is expressed in pips. The higher the ATR, the greater the volatility and vice-versa. The advantage of using market indicators to decide where to place your stops is that you can maximize your profits and minimize your losses based on recent price data. This is particularly important in volatile markets where the trader might have difficulty deciding where to place the stops, to the point where he might be indecisive and decide not to use stops at all.
Trailing Stops
In contrast to static stops, trailing stops are adjusted based on the direction the trade moves. To illustrate how this works, let's say you bought the currency pair EUR/USD at 1.2500, and set your stop loss at 1.2450 and your take profit at 1.2600. If the price moves up 50 pips to 1.2550, the trader may consider moving the stop-loss up to the entry price of 1.2500. Even if the price should fall again and trigger the stop-loss order, at least the trader will not suffer a loss since he is exiting the trade at his buy-in price.
If the price moves up to 1.3000, the trader may decide to remove the take-profit order and instead trail the stop loss. For example, he may choose to move the stop to 1.2550. That way, even if the trade moves against him, the trader still enjoys a 50-pip profit. Among the ways of creating trailing stops are:
- Dynamic stops. Under this method, the stop is adjusted every time the trade moves in favor of the trader. To illustrate, let's say the price moves up to 1.2501 or one pip above the buy-in price, the stop will also be adjusted by one pip to 1.2451.
- Fixed stops. Using this method, the trader will adjust the stops on an incremental basis. For example, if the price increases by 10 pips, the trader will also increase his stop by 10 pips.
Content credit: www.mtrading.in , An Indian Forex broker.
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