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Forex Definitions: Stop Loss, Take Profit and Trailing Stop Orders

admin on August 22nd, 2008

In the world of currency investing, the three terms “stop loss”, “take profit” and ”trailing stop” are widely used, since they are the best known kind of limit orders that are used to close a trade under specific conditions, allowing the investor to greatly reduce its risk exposure and trade with more serenity.

A Few Initial Assumptions

For explanation purposes, let’s make the following assumptions:

• we went “long” on a standard 100,000 EUR/USD lot on a USD account, which means buying $100,000 worth of EUR;
• the current EUR/USD bid price is 1.5000, which means we bought €66,666.67 (that is, $100,000 worth of EUR).

As we already explained, a PIP is defined as the minimum variation that can occur in a trade, which is 0.0001 for EUR/USD as well as most of the other pairs. We can calculate the value of a PIP for any given trade by multiplying 0.0001 to $100,000 and see that any minimum variation gives us a profit or a loss of exactly $10.

Since the forex market is extremely volatile, we want a way to protect our investment: luckily, we can do this with stop, limit and trailing stop orders.

Stop Loss Orders in Forex

A stop order is a way to protect ourselves in the worst-case scenario. Setting it at a distance of -20 PIPs, for instance, means (under the conditions explained above) that for this particular trade we won’t be losing more than $10 x 20 = $200. You’ll find it extremely useful to be able to precisely monitor the risk exposure of all your open trades.

Take Profit (or Limit) Orders in Forex

Conversely, a take profit (or limit) order is a way to somehow “save” your profits, meaning if you reach a certain ask price, you will automatically sell. If you for instance set a limit at a value of +40 PIPs, you’ll know the maximum you can profit from a trade is $10 x 40 = $400.

Placing a limit order is extremely important as it helps you keeping your trade objectives clear for all of its duration and avoids the (very realistic) possibility that greediness will take over and damage your trade. If you don’t have a clear objective from the very beginning, you’ll never want to close a trade since you’ll be constantly looking for more and more profits, but chances are you won’t want to close it even when the pair has made its peak and started to retrace, eventually leading you to lose on a potentially positive trade.

Trailing Stop Orders in Forex

A trailing stop order is another interesting possibility, very useful especially in volatile markets. Let’s suppose you placed a trailing stop at 1.5100, and the pair initially goes at 1.5150, then makes a swing back at 1.480, when your stop and limits are at 1.4900 and 1.5200 respectively. What happens here?

Without a trailing stop, you would exit the trade with a stop loss at 1.490, losing $100. But with a trailing stop, you would profit $100 under exactly the same conditions! A trailing stop is triggered when the pair price reaches a certain value, 1.5100 in our example, and replaces the former stop loss.

That way, when the pair reaches 1.5100, the trailing stop is triggered and somehow “saves” your profits, triggering a stop loss exit in case the pair starts going down from there, and of course the limit order otherwise.

As we hope you realized, using stop, limit and trailing stops often makes a difference between a good and a bad trade, and learning how to use them profitably is an essential part of your training as a forex investor.