What is a Stop Order and How to Use it

The simple definition of a ‘stop’ order is that it is an order to buy or sell at a less advantageous price than is currently available in the market. The obvious question is why anyone would want to do this?

The answer is that ‘stop’ orders are used to limit an investor’s exposure in the market. Traders place ‘stop’ orders to protect themselves from adverse market moves. This should always be a part of a trading plan. In other words, a trader should know in advance of placing a trade where to close it should the market move against him or her. More often than not, prices will move against you at some stage.

Sometimes this may just be a minor short-term move, but at other times it may mean that you’ve got the market direction wrong. So the aim is to work out the best place to put your stop to give you the best opportunity to make money while taking the smallest amount of acceptable risk.

Where to place your stop order?

The first step is to work out how much of your trading capital you’re prepared to risk on any one trade. This is covered under ‘Money Management’ and essentially involves divide up your trading funds into a number of smaller packages to ensure you never risk too much on a single trade.

The next thing to consider is risk management which is where stops come in. Risk management involves technical analysis and this means studying charts. Prices are constantly moving, and often they create patterns which become visible when plotted on a chart. While chart patterns can’t predict where prices will go in the future, they can help identify whether a market is trading in a range or is trending in a particular direction.

Areas of support become apparent when prices repeatedly bounce off a certain area. Resistance builds when prices repeatedly pull back from a particular area. By attempting to buy near support and sell near resistance it’s possible to increase the likelihood of a successful trade. Then a sell-stop can be set below a support area while a buy-stop should be placed above resistance. In this way traders can protect themselves if prices break out from the range or trend.

What are stop-orders and limit-orders and how do I use them?

This tends to be one of the most common questions for newer traders, and even people who have been trading for some time aren’t always 100% percent clear on the differences between the two. These orders are how new trades are executed and come in two forms: market orders and pending orders.

Market orders are executed at the current market price. So, for example, let’s say that you wish to enter a long position on EUR/USD and click the ((buy)) button, you will be entered into a long position at the current market price. Depending on your trading style this may be your preferred method of entry to take swift action and enter the market there and then. The downfall to this approach is that price can move very rapidly at times and if you’re executing a market order you may not get filled at the level you anticipated. This may result in you taking on more risk than you had originally allowed for.

Another drawback of trading with market orders is that you would have to be present and

tracking live price to execute your trade at your desired price. Pending orders are a good alternative to market orders as you would enter a position if, and only if, price reaches a certain level.

For example, your analysis flags potential weakness in gold so you wish to enter a short position on this metal if price falls beneath a support level at X price. We would then place an order into the market and it will only be filled when price gets to that level.

Once we have placed the order we no longer need to sit in front of that chart waiting for our entry level. This has several benefits not least that we are far more likely to be filled at our original level, but it also means that we can trade around our other commitments, the most obvious being a full-time job.

Take profit and stop loss orders

Take profit orders and stop loss orders are a different type of order that will allow you to automatically exit a position, whether the trade has gone in your favour, or if it has gone against you.

A stop loss order will be triggered when price reaches the point where you have decided you wish to exit your position in the event the trade has gone against you. A take profit order will be triggered when price reaches the point you wish to exit the trade if price has moved as you had anticipated. The use of these orders means that you don’t need to be constantly monitor your charts when in a position and allows you to take a structured approach to your trading. Management of risk is one of the most critical aspects of trading and the use of a stop loss order is integral to this.

The location of your stop loss order should be driven by your strategy and placed in a logically valid location. The use of a stop loss order in conjunction with the size of your position will dictate the size of the loss if the trade goes against you, as such both variables need to be carefully considered prior to entering a position.

The location for take profit orders will also be driven by your strategy and, again, needs to be placed in a logical location. When assessing potential targets for a trade one always needs to be mindful of the risk to reward ratio for the trade.

  • BrokerEUR/USD
    LCG 0.3pips (variable) margin: 3.33%
    SpreadEX 0.6pips (variable) margin: 3.33%
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