Author: Kesavan Balasubramaniam
Source
The high amounts of leverage commonly found in the forex market offer investors the potential to make big gains but also to suffer large losses. For this reason, investors need to employ an effective trading strategy that includes both stop and limit orders to minimize their potential losses.
Stop and limit orders in the forex market follow the same rules as in the stock market:
- A limit order allows an investor to set the minimum or maximum price at which they would like to buy or sell.
- A stop order allows an investor to specify a price at which they will buy or sell a currency pair.
An investor with a long position can set a limit order at a price above the current market price to take profits and a stop order below the current market price to cap losses. An investor with a short position will set a limit price below the current price as the initial target and also use a stop order above the current price to limit losses.
Key Takeaways
- Relatively small moves in currency markets can generate large profits or losses due to the use of leverage.
- Stop and limit orders are crucial strategies for forex traders to limit margin calls and take profits automatically.
- Both stop and limit orders are flexible, with most brokerages allowing a wide range of contingencies and specifications for each order type.
Understanding Forex Stop and Limit Orders
There are no rules that regulate how investors can use stop and limit orders. Deciding where to put these control orders is a personal decision based on the investor’s risk tolerance. Some investors may decide that they are willing to incur a 30- or 40-pip loss on their position, while other, more risk-averse investors may limit themselves to a 10-pip loss.
It is generally wise to avoid being too strict with price limitations. If the stop and limit orders are too tight, they will be constantly filled due to market volatility.
Stop orders should be placed at levels that allow for the price to rebound in a profitable direction while still protecting from excessive loss. Limit or take-profit orders should not be placed so far from the current trading price that it represents an unrealistic move in the price of the currency pair.
Types of Stop Orders
A stop order becomes a market order once a specified price is reached. It can be used to enter a new position or to exit an existing one.
A buy-stop order is an instruction to buy a currency pair at the market price once the market reaches your specified price or higher. The buy price needs to be higher than the current market price.
A sell stop order is an instruction to sell the currency pair at the market price once the market reaches your specified price or lower. The sell price needs to be lower than the current market price.
How to Use Stop Orders
Stop orders are commonly used to enter a market when you trade breakouts.
For example: suppose that the U.S. Dollar/Swiss franc (USD/CHF pair) is rallying toward a resistance level. Your analysis suggests that, if it moves above that resistance level, it will continue to move higher.
You can place a stop-buy order a few pips above the resistance level so that you can trade the potential upside breakout. If the price later reaches or surpasses your specified price, this will open your long position.
An entry stop order can also be used if you want to trade a downside breakout. Place a stop-sell order a few pips below the support level so that when the price reaches your specified price or goes below it, your short position will be opened.
Stop Orders Limit Losses
Everyone has losses from time to time, but what really affects the bottom line is the size of your losses and how you manage them. Before you enter a trade, you should have an idea of where you want to exit your position should the market turn against it.
One of the most effective ways of limiting your losses is through a pre-determined stop order, which is commonly referred to as a stop-loss.
If you have a long position on the USD/CHF, you will want the pair to rise in value. To avoid any possibility of uncontrolled losses, you can place a stop-sell order at a certain price so that your position will automatically be closed out when that price is reached.
A short position will have a stop-buy order instead.
Stop Orders Protect Profits
Once your trade becomes profitable, you may shift your stop-loss order in the profitable direction to protect some of your profit.
For a long position that has become very profitable, you may move your stop-sell order from the loss to the profit zone to safeguard against a loss if your trade does not reach your specified profit objective and the market turns against your trade.
Similarly, for a short position that has become very profitable, you may move your stop-buy order from loss to the profit zone to protect your gain.
How to Use Limit Orders
A limit order is placed when you are only willing to enter a new position or exit a current position at a specific price or better. The order will only be filled if the market trades at that price or better.
A limit-buy order is an instruction to buy the currency pair at the market price once the market reaches your specified price or lower; that price must be lower than the current market price. A limit-sell order is an instruction to sell the currency pair at the market price once the market reaches your specified price or higher; that price must be higher than the current market price.
Limit Orders Are Used to Fade a Breakout
To “fade” a breakout is to bet against the prevailing trend.
This strategy could be used when you don’t expect the currency price to break successfully past a resistance level or a support level. In other words, you expect that the currency price will bounce off the resistance to go lower or bounce off the support to go higher.
For example, suppose you think that USD/CHF’s current rally is unlikely to break past a resistance level. Therefore, you think that it would be a good opportunity to short USD/CHF when it rallies up to a level near that resistance.
To take advantage of this theory, you can place a limit-sell order a few pips below that resistance level so that your short order will be filled when the market moves up to that specified price or higher.
Besides using the limit order to go short near a resistance, you can use this order to go long near a support level. For instance, if you think that there is a high probability that USD/CHF’s current decline will pause and reverse near a particular support level, you may want to take the opportunity to go long when USD/CHF declines to a level near that support.
In this case, you can place a limit-buy order a few pips above that support level so that your long order will be filled when the market moves down to that specified price or lower.
Limit Orders are Used to Set Your Profit Objective
Before placing your trade, you should already have an idea of where you want to take profits should the trade go your way. A limit order allows you to exit the market at your pre-set profit objective.
If you long a currency pair, you will use the limit-sell order to place your profit objective. If you go short, the limit-buy order should be used to place your profit objective.
Note that these orders will only accept prices in the profitable zone.
Is the Forex Market Regulated?
In the U.S., regulation of the forex and all other commodities markets is the responsibility of the Commodity Futures Trading Commission. (CFTC).
That said, the forex is a global decentralized market with no owner and no physical presence, making it tough to regulate. It was once a hotbed of scams but vigorous enforcement by the CFTC and the emergence of a self-regulating forex broker system has shut down many of the bad operators.
What Is the Forex in Plain English?
Whenever you go on vacation to a foreign country, you trade the forex. You pay a number of dollars to get X number of euros or yen. If your timing is right, you get more euros or yen for your dollars because those currencies have increased in value against the dollar.
The forex market exists to exchange money, at high speed and in vast quantities. Some traders are representing businesses that need to buy yen with dollars to do business with Japanese companies. Many traders are there to make a profit from the constant fluctuations in value between the U.S. dollar and the Japanese yen, or between the British pound and the euro.
That’s why all transactions on the forex are in pairs: USD/JPY or GBP/EUR.
Is the Forex a Volatile Market?
Yes, the forex is volatile. Every currency is subject to unpredictable political and economic headwinds. Moreover, many forex traders rely on leverage, meaning they’re trading with borrowed money to increase the impact of a change in a currency’s value.
The Bottom Line
Having a firm understanding of the different types of orders will help you to use the right tools to achieve your intentions—how you want to enter the market (trade or fade), and how you are going to exit the market (profit and loss).
Market, stop and limit orders are the most common orders on the forex. Be comfortable using them because improper execution of orders can cost you money.
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