As a trader, the most important role is to manage and protect your trading capital. How can we achieve this? By making use of a stop loss and take profit.
If you lose all of your capital, there is no way to recoup your losses; you are out of the game unless you top up your account again. On the other hand, if you make pips, you must be able to hold them and not give them back to the market.
Still, let’s be honest. The market always does what it wants and shifts in the direction it wants. Every day is a challenge, and almost everything from unexpected economic data releases, central bank policy speculation to presidential tweets can influence currency prices.
So, how can you stop giving away your profits and keep what you have made?
Easy!
By setting stop loss and take profit.
Don’t fret if you haven’t heard of these terms, and if you have, we’ll explain every inch of detail about stop loss and take profit orders.
So, make sure to stick around till the end.
Stop Loss
First, let’s talk about stop-loss.
A stop-loss order is placed to exit your trading position in a loss at a certain price.
These orders help to limit the amount of loss that you can suffer in a position. So, if you set your stop-loss order at 1% below the price at which you bought the pair, your loss would be limited to 1%.
Here’s an example. If you buy GBP/USD at $1.3850 and place a stop-loss order at $1.3800, your stop-loss order will hit when the price reaches $1.3800, thereby preventing further loss. If the price never dips down to $1.3800, then your stop-loss order won’t execute.
Now that you know about stop-loss, a term commonly used with it is a trailing stop.
A trailing stop is a type of stop order that can be set at a certain level away from the current market price.
If your trade is profitable, the trailing stop will move with the market price. As a result, if markets turn in your direction, the percentage of loss you’re able to bear stays unchanged.
If the market inevitably shifts against you, the trailing stop, which has risen in parallel with your profit, saves you from losing your recent gains.
Types of Stop Loss
There are two types of stop loss orders you need to remember:
Sell Stop Order
Sell stop orders allow you to place a stop price to sell. The sell order gets triggered when the market reaches the stop price. Sell stop orders may face some slippage as well.
A keynote to add here is you have to look for slippage. Forex slippage appears when a market order is executed, or a stop-loss closes a position at a rate that differs from the rate specified in the order. Slippage is more likely to occur when uncertainty is high, such as after a news event or when the pair is trading outside of its peak market hours.
Stop Limit Orders
The stop limit order is another form of a stop loss order.
When the price of a pair hits your stop loss level, your broker will automatically send a limit order to close the position at the stop loss level or at a higher price.
Unlike a stop-loss market order, which will close the trade at any price, a stop-loss limit order will only close the trade if the stop-loss price is reached or exceeded. This removes slippage.
Ok, let’s move to take profit.
Take Profit
A take-profit order is a kind of limit order that defines the exact price at which a position should be closed for a profit. If the pair’s price does not meet the maximum price, the take-profit order is not filled.
Since it prevents more profit growth, it guarantees a certain profit after a certain amount is reached.
For example, if you are long EUR/USD at 1.1900 and you want to take your profit when the price reaches 1.2000, you will set this rate as your take-profit level.
If the bid price touches 1.2000, the open position is closed automatically, securing your profit.
Short-term traders, such as scalpers, who want to manage their risk, should use take-profit orders. This is because you’ll exit a trade as soon as your profit goal is met, avoiding the possibility of a potential market reversal. Traders with a long-term strategy despise such orders because they reduce their earnings.
How to Calculate Stop Loss and Take Profit?
You need to use take profit orders in combination with stop-loss orders to manage your trading positions. If the price of the pair increases to the take-profit level, the T/P order is executed, and the position is closed profitably. If the price falls below the stop loss level, the S/L order is executed, and the position is closed at a loss.
The question everyone has is how to calculate stop-loss and take profit?
Well, it depends on your risk/reward ratio. You can’t place take profit or stop loss orders randomly.
Before placing a stop loss and a profit target, you need to determine the risk/reward ratio of the trade. You can either make this or lose that, and you can decide whether to take the trade based on that detail.
Using a fixed reward/risk ratio is one of the easiest methods for determining a profit target. The stop-loss will decide how much you lose on the trade based on your entry point. The profit target is a multiple of this, such as 1:2.
For instance, if you buy EUR/USD at 1.2520 and place a stop-loss at 1.2526, you are risking 6 pips on the trade. If using a 1:2 risk/reward, your profit target should be set 12 pips from your entry point at 1.2532.
You must develop a trading strategy that specifies how you will enter trades, manage risk, and exit profitable trades. You can easily calculate your stop-loss and take profit this way.
Bottom Line
If you are just starting out, keep trading simple. Trade in the overall trending direction, and set your take profits and stop losses according to your risk/reward ratio. In this way, you won’t blow up your account on one single trade.