In the world of currency trading, the three terms stop-loss, take-profit, and trailing stop are widely used, since they are the best known kind of stop and limit orders that are used to close a trade under specific conditions, allowing the trader to greatly reduce the 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.
- The current EUR/USD Ask price is 1.5000, which means we paid $150,000.
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 by 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 trade: luckily, we can do this with stop, limit, and trailing stop orders.
Stop-Loss Order
A stop-loss order is a way to protect ourselves in the
Take-Profit Order
Conversely, a take-profit (based on a limit pending order) is a way to somehow "save" your profits, meaning if you reach a certain Bid price, you will automatically sell. If you, for instance, set a TP at a value of +40 pips, you will know the maximum you can profit from a trade is
Placing a take-profit order is extremely important as it helps you at keeping your trade objectives clear for all of its duration and avoids the (very realistic) possibility that the greed will take over and damage your trade. If you do not have a clear objective from the very beginning, you will never want to close a trade since you will be constantly looking for more and more profits. But chances are you will not 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 in Forex
A trailing stop is an interesting mechanism, very useful especially in volatile markets. Suppose you activate a trailing stop to trail your profit at a 50 pips distance, and the pair initially goes from 1.5000 to 1.5150, then makes a swing back at 1.4800, when your SL and TP are at 1.4900 and 1.5200 respectively. What happens here?
Without a trailing stop, you would exit the trade at the original stop-loss level at 1.4900, losing $1,000. But with a trailing stop, you would profit $1,000 because the stop-loss would be moved to 1.5100 when the price had reached 1.5150. A trailing stop continuously adjusts stop-loss level as the currency price advances in our favor, but does not move it when the price reverses.
That way, when the pair reaches 1.5100, the new stop-loss level is triggered and somehow "saves" your profits.
As we hope you realized, using stop-loss, take-profit, 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 trader.
