How to Use Stop & Limit Orders to Improve Trading Performance
Use of stop orders and limit orders provide automatic execute buys or sells of forex contracts. If structured properly, they can provide:
- more secured way to buy (or sell) when the market is moving in the direction the trader has forecasted
- an automatic safety net to limit losses when the market moves in the opposite direction.
To be used successfully, the trader have be able to accurately calculate the direction of the market for a currency pair, the size of the movement and the volatility of the market.
By placing a limit order, a trader is telling a broker to execute a trade at a certain price or better (given the direction desired by the trader). A stop order is activated when the value of a forex contract reaches or passes the stop order line. At that point, the contract is executed at the market price.
Sell stop and sell limit order example in Forex trading
For example, a trader forecasts that the EURUSD rate will increase rapidly in the near future. At the time the trader buys his contracts, the rate equals 1.3130. Since the trader expects a sharp run, he sets a limit order at 1.3180. To mitigate his losses, if his forecast is incorrect, he sets a sell stop order at 1.3100. In this example, there are several possible outcomes:
- Everything goes as expected. The rate climbs to 1.3180, and the contracts are sold as per the limit order. The trader makes a profit of 50 pips per contract.
- The rate roars right through 1.3180 to 1.3200, where it settles. The limit order is executed and the trader makes the 50-pip profit as per the limit order, plus an additional 20-pip profit on what is called slippage. (This is perhaps the best part of the limit order.)
- The rate changes, but does not reach an upper limit of 1.3180 or a lower limit of 1.3100. Neither the limit order nor the stop order is executed, and the trader continues to hold the contracts within the 80-pip zone (unless he manually sells the contracts at whatever price the market settles).
- The rate drops against the trader’s expectations to 1.3100. The stop order is executed and the trader takes a loss of 30 pips per contract, but his losses are no greater than that amount.
- The rate drops below 1.3100 (at which point the sell stop order is executed, with the resulting loss for the trader), but later rebounds, perhaps to its starting point or higher. Since the contracts were sold at the stop order price line, the trader cannot recoup his losses – or make a profit – when the price recovers.
As the above example shows, the trader must accurately predict not only the direction and degree (that is, the amount) of the change in the exchange rate, but also the volatility of the rate change.
Placing the limit order price too far above the starting price will mean that the order will not be executed because that price line is not crossed, let alone exceeded. If the sell stop order price is set too close to the starting price, it may not adequately allow for market volatility and potential recovery. A narrow band set for a stop order below the start price will reduce the risk for the trader, but it will also reduce the potential for recovery if the rate rebounds. The width of the band is, in the end, determined by the trader’s risk tolerance, but it can also be affected by his experience and the market intelligence upon which he bases his trades.
Guest post contributed by Liz Goldman.