The forex market surely gives a lot of opportunities to earn profits, but the probability of losses is always there. This risk makes many of us reluctant about forex trading and stops us from entering the dynamic currency market as a beginner. Successful forex trading requires the right amount of knowledge, skills and a solid strategy to make calculated moves to gain from the favourable fluctuations in currency pair prices. But this process may often seem like a complex puzzle for an average newbie. The missing piece that completes this puzzle would be risk management, which is the most relevant part of forex trading.
This article is written to teach you about risk management in forex by using Stop Loss and Take Profit in an optimal manner and learning to place them properly while trading for real.
Why do you need Stop Loss and Take Profit to trade?
Before getting into the technicalities of Stop Loss and Take Profit, we need to understand the basics and why we need to use them in the first place while trading. When we place a trade, we are somewhat trying to predict the direction in which the exchange rate will be moving. Suppose you choose to trade with the pair USD/JPY; the price of this pair represents the value of USD with Japanese Yen as the quoted currency. So, we look at the price charts or do some fundamental analysis to determine the potential price movement. If we expect USD to gain in value against Yen, we will place an order to buy the pair and plan to sell it after the price reaches a level where we can lock profits. If we see the possibility of a price drop instead, we will enter a trade to short the pair for profits.
In any case, there is no guarantee that the price will move in our favour as the market can always fluctuate in an unpredictable manner. Hence, we need to plan for the worst-case scenario and place a Stop Loss for an automated exit when the price starts moving in the opposite direction of what you had predicted, leading to a losing trade. A Stop Loss aims to close a losing trade at the right point to minimise account drawdown and safeguard your trading capital. It is a powerful tool to manage the risk and let the trade run freely without keeping your eyes glued to the screen throughout the trade. A ‘Take Profit’ order is similar, but the intention here is to exit a profitable trade at the right point to realise profits and avoid the risk of losing it due to a sudden reversal.
How to place a Stop Loss order in Forex?
You need to keep certain things in mind while placing a Stop Loss. The first one is your own risk appetite or risk tolerance, which determines the maximum amount you are willing to risk or the amount of trading capital you can afford to lose in a single trade. But you should not be placing an SL right next to your entry price. Because in that case, your trade is at risk of being closed even before it starts moving due to the minor sideway movements that happen during a trade. Hence, the Stop Loss needs to be wide enough to keep your trade running until the analysis becomes invalid due to the market moving in a different direction than what you had planned for.
The price movements in the forex market are always measured in pips, and thus, it is easier to put a Stop Loss based on pip value. I strongly suggest using free tools like pip calculators to determine the value of pips in your account’s base currency and place a Stop Loss based on that calculation. For instance, you may choose to exit a trade once it is at a 20-pip loss and place the SL at this level. 20 pips SL is considered ideal for day trading forex, but you should make a decision based on your own risk management plan.
Popular strategies for placing Stop Loss
There are several popular techniques and strategies that you can follow for placing a Stop Loss. Below, I have listed some of the most commonly used stop-loss strategies, and you can choose the most suitable one for yourself based on the trade setups you prefer.
1. Pin Bar Strategy Stop Loss: Stop loss placement for the pin bar strategy is made beyond the high/low of the pin bar tail.
2. Inside Bar Strategy Stop Loss: Stop loss for inside bar strategy placed beyond the mother bar high/low.
3. Counter-trend Price Action Stop Loss: Stop loss for counter-trend setup beyond high/low, indicating potential trend change.
4. Trade Range Stop Placement: Place stop loss at the trading range boundary or high/low of setup. This one is for traders using a price action setup.
5. Stop Placement in Trending Market:
● Option 1: Stop above/below pattern high/low.
● Option 2: Use the level for stop placement and place it under the level.
6. Trending Market Breakout Play Stop Placement:
● Breakouts after consolidation offer trading opportunities.
● Stop placement: near 50% consolidation level or opposite side of the setup.
How do you place take-profit orders in forex?
Take Profit orders are placed to exit the trade at a profit; hence, your profit potential for the trade will be limited to the Take Profit level. Hence, you need to ensure your Take Profit is not too tight, as it will reduce your profits for the trade even when the market continues moving in your favour. But it is useful for those who are unable to keep an eye on the trade while it’s running and want to exit the winning trade as soon as possible. Those who aim for small profits in a trade can place modest Take Profit, while those who are ready to wait for a larger gain can make it more flexible by placing a wide TP.
But you need to take the market volatility into consideration while determining your Take Profit since you can’t expect to hit a higher profit target when the market is just stuck within a range without any clear trends. Like Stop Loss, traders determine their Take Profit based on the number of pips they aim to gain from a trade. So, based on your trading plan, you can place a Take profit with the calculation of closing the position when it is at 20 pips profit or more. I will also suggest using a profit calculator to calculate exact take profit levels in a way that the profit potential is not compromised. That way, you can set the TP at an optimal point based on the most probable outcome of the trade.
Setting Profit Targets
Setting your profit target is closely connected to your risk/reward ratio, which is another powerful tool for risk management in forex trading. The risk/reward ratio tells how much reward you expect and how much you are willing to risk for the sake of that reward or profits in a trade. A high risk/reward ratio naturally results in a higher profit target, allowing you to balance the gains and losses in the best possible manner. A high risk/reward ratio allows you to make enough profits even with a low win rate, whereas a higher win rate will be required to make things work with a low risk/reward ratio. So, always confirm that the trade setup and the profit target are in line with your risk/reward ratio before entering the trade.
General Profit Target Placement Theory
This theory is about determining an optimal stop-loss placement followed by identifying a suitable profit target and risk/reward ratio. A trade's viability hinges on maintaining a favourable risk-to-reward ratio. The process entails pinpointing logical Stop Loss and Take Profit positions. If the trade exhibits a decent risk/reward ratio, it's worth considering. Be logical, and don't disregard market levels or obstacles for the sake of entering a trade. Analysing market conditions, support/resistance, turning points, and key levels is crucial. Assess whether feasible Take Profit points exist or if anything is blocking profitable trade execution.
How do you place Stop Loss and Take Profit on MT4?
To set Stop Loss and Take Profit on MT4, open a trade, right-click the order, select "Modify or Delete Order," then set desired values for Stop Loss and Take Profit. You can let the trade run freely after confirming the changes.
Conclusion
To summarise, proper usage of Stop Loss and Take Profit orders is important for executing a trade within a safe zone. You can always rely on tools that automate the calculation process to get instant and accurate metrics. Focusing on risk management is essential to survive unfavourable market situations with ease.
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