The use of stop loss is very important for risk management in forex trading. Before entering into any trade, you need to be very clear on the level of risk that you will take in that trade. Suppose, you spot a high probability swing trade setup with risk to reward ratio of 1:3!
How do you calculate the risk to reward ratio?
Your risk is the amount you are willing to lose if the trade goes wrong. Suppose, you are willing to lose $500 in that trade. $500 translates into 50 pips on a standard account. The reward is your profit target. It should be $1,500 or 150 pips to give you a risk to reward ratio of 1:3!
Some traders may not be comfortable with 50 pips stop loss (SL). You are the best judge on how much risk you want to take. In swing trading on higher time frame charts like the daily chart, you will have to use a SL between 30-50 pips in order to give the trade some room to work out. Too tight a stop loss something like 20 pips and the chances are that it might get tripped soon by the noise. Too wide a stop loss and you risk losing too much.
So always decide on the SL very carefully when you enter into a trade. Where to place the initial SL of 50 pips? If you use candlesticks, you can use the candlestick patterns to tell you where to place the SL. In fact, a good trading system will tell you where to place the stop loss.
Now, when the trade goes well and starts moving in the direction that you had wanted, you can move the SL with the daily movement of the trendline. Another approach in case of trend trading is to use a trailing stop. Once the trade becomes profitable, replace the initial stop with a trailing stop.
A trailing stop trails the price action by the amount of pips that you specify. For example, you put a trailing stop of 20 pips in an uptrend. This trailing stop loss will always trail the price action by 20 pips. This way, once you are profitable, you can continue in the trade as long as the trend continues.
When the trend reverses and price action retraces by 20 pips, this trailing stop will be tripped and you will be out of the trade. Whatever, use of a stop loss is an art that you should not ignore. With practice and experience, you will be able to know the best place to put the stop loss.