Forex and CFD trading is a leveraged product which means that if the markets move against your positions, your losses will be multiplied by the leverage ratio you have selected. Some traders opt to use a high leverage ratio as it can multiply their profits when the markets move to the direction they have placed their position on, but they should also be aware that a higher leverage ratio also translates to higher losses. When a trade does go wrong, there are only two options: to accept the loss and liquidate your position, or go down with the ship.
This is why using stop orders is so important. Many traders will hold on to losing trades hoping that the markets will reverse – it’s simply human nature. We take profits because it feels good and we try to hide from the discomfort of defeat. A properly placed stop loss order helps traders close their positions automatically before they end up draining their entire balance. In essence a SL acts as insurance against losing too much. In order to work properly, a stop must be placed based on the following question: At what price is your opinion wrong?
To answer this question one must take into account the situation pertaining each trade. Is there a lot of volatility for example? Is it a long or short position? Are there important news, that could have a major effect on your traded asset, coming up? What is the maximum percentage of price change beyond which you think the losses would exceed your risk tolerance? More importantly if you have multiple trades running, it is important to consider the overall risk you are taking with your SL orders. Worst case scenario, all your orders are stopped, what would be the overall loss? Would that be in line with your risk management strategy?
Another thing to keep in mind is that once your stop price is reached, your stop order becomes a market order and the price at which you sell may be different from the stop price. This is especially true in a fast-moving market where stock prices can change rapidly.
A stop-loss order is a simple tool, yet so many investors fail to use it. Stop loss orders allow decision making to be free from any emotional influences. People tend to fall victims of their emotional biases, stretching out losses, in the hopes that a trade could turn around, defying their own risk management strategies. Stop-loss orders can help traders stay on track with their risk management strategies without clouding their judgement with emotion.