In the Forex arena, there are only two ways you can get out of a position; by making a profit or by taking a loss. When referring to exit strategies, traders use the terms take profit and stop loss to determine the kind of exit being made. Take profit and stop loss levels are both orders which are placed in the market in order to close an open position. They are employed by traders to ensure that profits are taken for successful trades and to protect themselves from unnecessary losses. These orders form the most essential part of an investor’s risk management strategy and facilitate the controlling of the total potential loss and gain for each transaction.
Here, we discuss the importance of take profit and stop loss orders and demonstrate an easy way to set them.
What is a take profit order?
A take profit order, also known with the abbreviation T/P, allows traders to exit the trade at a pre-determined profit target. If you have entered a short position, the system will only allow you to place a T/P order below the current market price, as this is the profit zone. In the same way, if you have entered a long position, the system will only allow you to place a T/P order above the current price. For example, if you are long EUR/USD at 1.2688 and you want to lock-in your profit when the price reaches 1.2728, you can set this rate as your T/P threshold. If the bid price reaches 1.2728, the open position will be closed automatically and your profit is safeguarded. Setting a T/P level ensures that the trade exits in profit, in case that the market moves in the other direction.
What is a stop loss order?
A stop loss order, also abbreviated as S/L, enables traders to set an exit point for a losing position. If you have entered a short position, the S/L order should be placed above the current price. Likewise, if you have entered a long position, the S/L order should be placed below the current price. For example, if you are long USD/GBP at 1.6092, you could place a S/L at 1.5892. If the bid price drops to the level you specified, the position will be closed. A stop loss order operates as a defensive mechanism that controls your risk by capping losses, once the market moves against you.
Why are they so important?
Take profit and stop loss orders enable traders to form a disciplined trading strategy and eliminate the need to make emotional decisions during real-time trading. While different investors have different levels of how much they are willing to gain or lose from a trade, T/P and S/L orders allow this to be automated. Moreover, they make it possible for individuals to leave their screen, without constantly monitoring the market.
The volatility that may arise in financial markets from the sudden release of unexpected news, political events or economic conditions, can cause huge market movements and, thus, heavy losses. Stop loss orders may effectively lower your exposure to risk. What is more, the leverage used in Forex suggests that any price move will have a proportional impact on your capital. There is a possibility to lose your margin funds and be asked to deposit extra money to keep your position open. In case that you fail to respond to the margin call within the required time, your position will be closed and you will be responsible for any resulting losses. Thus, traders should always employ stop loss levels in order to prevent such scenarios.
How to set take profit and stop loss orders effectively?
Let us assume that your technical and fundamental signals point to the same direction and you feel that you have a good chance of earning a profit, so you decide to open a position. Before entering that trade, you should clearly establish the reasons for making that move. You should work out how far you believe the price will go in your favour and have a conviction, as to what the actual number might be. Once you have figured this out, it is quite easy to set your T/P and S/L orders correctly.
One of the first things that you need to determine is the risk reward ratio. This is one of the most fundamental trading concepts that need to be learnt from the first trade you ever place. Simply put, risk is the amount of funds that you may lose in a trade (no more than 2-3% of your investment in each transaction). Reward is the profit that you may make in a trade. The larger the profit target (T/P) against the loss (S/L), the smaller the risk reward ratio, meaning that your risk is smaller than your reward. The recommended risk/reward ratio for a Forex trader is 1:3.
So, what is the actual process of setting T/P and S/L orders? Once you have thought about the distance of the current price to your target price in pips, write it down. Then, take the total number of pips from the current price and divide this number by the reward value to establish the risk ratio. Knowing the risk reward values, proceed with the calculation of the distance from the current price (in pips) for both the risk and reward value and place these two numbers as you T/P and S/L levels.
For example, say that the current market price for EUR/USD is at 1.2800. Your indications suggest that the market will be bullish, so you decide to go long on the pair. You presume that the price will go to 1.2890 at a minimum. Doing the calculation, you take out the target price of 1.2890 and subtract the current price of 1.2800 (1.2890 – 1.2800 = 90 pips).
Now that you determined the target price is 90 pips away from the current price, you decide to use a 1:3 risk reward ratio. To calculate the value in pips of the risk value based on the 1:3 ratio, you divide the total number of pips (reward) by the reward ratio. That is 90 pips / 3 reward = 30 pips/risk.
In order to set a T/P and S/L order with the corresponding values, you take the current price and add the reward value and then subtract the risk value from the current price. Keep in mind, that when calculating the values, you need to keep them in the same format as the spread. Thus, the T/P level is 1.2800 + 0.0090 = 1.2890 and the S/L level is 1.2800 - 0.0033 = 1.2770.
Although a trader should not get into the habit of resetting stop losses once the trade is active, a number of traders move their S/L orders to the position opening level, as soon as the price moves into the profit zone by 20 – 30 pips. By moving the S/L to the entry price, a trade becomes risk-free, as you secure a break-even as your worst case scenario.
Setting stop loss and take profit orders is critical to your trading safety and you should use them with every trade that you make. Without the added protection of these orders, you could find yourself incurring unnecessary losses.