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In forex trading, the stop loss is an essential risk management tool that every trader should be using. Its effectiveness lies in its simplicity; by specifying their loss limit ahead of time, traders can manage unexpected market behaviour. Unfortunately, many brokers make this simple concept overly difficult to execute. Things like slippage and market gaps often mean that traders cannot set an absolute limit on their potential loss. That’s why guaranteed stop-losses are extremely important, and why new forex traders should only accept a broker that allows you to specify an absolute limit on your loss.
A stop loss order is a type of advanced order placed with a broker to sell a security when it reaches a certain price, thus limiting the trader’s loss on a position.1 This makes stop loss orders different from conventional market orders, where a trader simply specifies the type and number of securities they wish to buy at the current market price.2 While stop loss orders are usually placed with a long position, they can also be used when shorting a security. In the case of shorting, the security would be bought if it moves above a predefined price.3
Setting up a stop loss order has a number of advantages. Some of these advantages include:
Having said that, there are some disadvantages traders should keep in mind when dealing with a stop loss. They include:
Fortunately, traders who set stops effectively never have to worry about these disadvantages. Successful traders use stop losses as insurance against unexpected movement rather than as an unintended way to limit upside.
A guaranteed stop loss allows traders to place an absolute limit on their loss without having to worry about slippage, which is the difference in points between your desired price and the one you can actually deal on. A number of factors impact slippage, such as a fast-moving market, an illiquid market with uneven supply/demand for a particular security and a large number of stops placed around the same level.
1. Stop-Loss Order. Investopedia.
2. Chris Gallant. “How does a stop-loss order work, and what price is used to trigger the order?” Investopedia.
3. Stop-Loss Order. Investopedia.
4. Stop-Loss Order. Investopedia.
5. The 4 Big Mistakes Traders Make When Setting Stops.