The foreign exchange market (or Forex) is not for traders and investors who lack passion and enthusiasm. A certain level of risk is always present in this market, as it is volatile and affected by a number of different factors. Luckily, there is a solution to keep your money involved in trading safe - a stop-loss order. What is a stop loss order? It is an order placed with a Forex broker to sell a security when it reaches a particular price.
The purpose of this article is to detail the differences between the guaranteed and non-guaranteed stop-loss, and the benefits you could gain from using the former.
Table of Contents
Stop Loss | Introduction
What is the Gap in FX Trading?
Guaranteed Stop Loss | What Does it Represent in Trading?
Conclusion
Stop Loss | Introduction
As you may already know, a Forex stop loss order is designed to limit an investor's loss on a position in a specific security. Though investors more commonly use stop-loss orders with long positions, they can also be applied to short ones, in which case the security would be purchased if it trades over a determined price.
Stop-loss orders, and guaranteed stop-loss orders also enable the ability to eliminate emotions while making trading decisions, proving to be exceptionally useful when a trader cannot watch the position. A stop-loss is also often referred to as a stop order or a stop market order.
Using a stop-loss order costs nothing to execute at all. Commission is charged only when the stop-loss price has been achieved, and the currency pair must be sold. In other words, you can think of it as a free insurance policy. Although it's good to not have to worry about your position with a stop-loss when you are not directly observing it, there is still a small disadvantage with its application, unlike the guaranteed stop-loss in Forex.
That disadvantage is that the stop price could be initiated by a short term fluctuation in a currency's price.
Therefore, the key is to select a stop-loss percentage that enables a stock to fluctuate normally, whilst preventing as much risk as possible. For example, establishing a 5% stop-loss on a currency pair that has a history of fluctuation of approximately 10% or even more within a week is not the best idea. You will most likely end up losing money from the commissions generated through the implementation of your stop-loss orders.
There are no hard and swift rules for the level at which stops must be placed - this depends entirely on your personal trading style. For instance, an active trader might use 5%, whilst a long-term investor might choose 15% or even more. Another thing to bear in mind is that as soon as your stop price is reached, your stop order turns out to be a market order, and the price at which you sell might be a lot different from the stop price.
This is particularly true in a fast-moving market, wherein currency prices can change in the blink of an eye. In order to protect against unexpected occurrences, a trader can use a Forex guaranteed stop-loss. Additionally, it is recommended that traders exercise risk management in their trading, to ensure they are fully aware of risks, and how to manage them.
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What is the Gap in FX Trading?
Prior to describing the guaranteed stop loss, we would like to briefly examine the Forex gap. In currency trading, the gap most commonly refers to the difference in price of a currency pair at the beginning of the new trading week, compared to the price at the preceding week's close.
In the strictest sense, those gaps are not actually gaps. As a matter of fact, gaps are merely a change of market anticipation beyond a single pip. In your FX charts, it shows up as a disconnected progression of candles. You need to know that in order to better understand why you may need a Forex guaranteed stop-loss.
In the context of unfavourable developments, an event, or an accident might have considerable influence, so much so that investors might suddenly have a different anticipation of exchange, which could then result in a jump of ask/bid rates. In the context of weekend gaps, with various participants in mind, whilst the majority of retail Forex brokers are closed for the weekend, the reality is that the world continues revolving, and economic announcements, events, or financial incidents will still occur. Without a guaranteed stop-loss, you may eventually lose a lot of money.
How can a trader handle FX gaps? No one can forecast what's going to happen in the foreign exchange market with 100% accuracy, so the best thing to do is to alleviate the risk of Forex gaps. It's for this reason that you need be consistent with practising appropriate money management.
Guaranteed Stop Loss | What Does it Represent in Trading?
What is a guaranteed stop-loss? (GSL) It is a stop-loss that is generally your insurance against disastrous losses or large FX gaps in the market that you are currently trading.
When volatility expands in a similar way to the start of the 2008 global financial crisis, you will find instruments such as stocks gapping permanently, as they continuously react to news from the US and London. For instance, when the US stock market falls over 350 points (around 3%), like it did on 26 July 2008, you can anticipate that the market is going to gap down substantially on open.
The market is a fine balance between sellers and buyers, also known as supply and demand. A gap up is the result of increased demand or more buyers flooding in, whereas a gap down results in more sellers or a greater supply hitting the market.
It is at this point that the GSL comes into play. Before we continue, we should mention that not all brokers offer GSLs. More often that not, it will be the market maker who offers this service. A guaranteed stop-loss in Forex is like an insurance policy. You can take it out with the intention of protecting your trades, but hopefully you will never have to use it. The main points of a GSL in currency trading are:
It can only be placed 5% away from the current close.
Its use is frequently at the discretion of your Forex broker.
It can be placed by phoning in, instead of having to go online.
There can be time limitations. For instance, you may not be able to place a Forex guaranteed stop-loss within thirty minutes of the stock market closing.
Many Forex brokers do not offer GSL at all.
They tend to cost more to place than a standard order.
Taking all of this information in consideration, let's consider who actually benefits from a GSL. The first group that comes to mind is traders who feel they need additional protection during times of uncertainty. It can also be useful for traders or speculators who trade with excessive amounts of leverage. The last group is traders who want a safety net for worst case stock market scenarios - i.e global crises, geopolitical and economic turmoil.
One might ask whether or not guaranteed stop-losses for Forex are really necessary in FX trading. Many full-time Forex traders want to keep their trading costs low, so guaranteed stop-losses do not really have a place in their trading portfolio. However, it comes down to your own tolerance for risk, or even more importantly - your own desire to remove the worst case scenario.
However, you may not require GSL if you trade with little or no leverage, and instead only trade with rational positions. Also, if you trade with the trend and utilise stop-losses that permit you to cut your loss off short, a GSL is not something that is vital for your trading.
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Conclusion
As you can see, a stop-loss order, especially a guaranteed one is a simple tool, yet many investors fail to use it correctly.
Whether preventing excessive amounts of losses, or just locking in profits, almost all investing styles can benefit from such a tool. Think of stop-loss as a warranty. You hope you will never have to use it, but it is nice to know you have the protection should you need it. If you trade with high levels of leverage, enjoy trading against the predominant trend, think selecting tops and bottoms is a good way to make money, and are happy to cover the costs, then Forex guaranteed stop-loss is exactly what you need.
