Hidden Perils Of The Stop Loss Order

By Author: Al Stewart
Total Articles: 2
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Hidden perils of the Stop Loss order

When you were a kid, did you ever fly a kite? If your kites flew like mine did
they always needed either more tail or less tail depending on who was advising you. And no matter what you did, sometimes the kite took off like a rocket and sometimes it fell like a rock.

I used to think, "If it can go up, why can't it just stay up!"

Well, now that a few(?) years have passed we are still flying our kites, but now we call them "Forex trading positions". And with the mostly unpredictable changes of the market our profits soar and sour just like our kites did.

Ah, but now, we have grown up and have a special tool at our disposal to keep our "kite"/profit from falling when the winds of the market change direction.

Direction change when flying a kite is a real pain, but a market without direction change would be no market at all. You can't buy low and sell high and make a profit if the high is at the same price as when you bought.

The special tool we have available in Forex trading is, of course, the Stop Loss order. It's the ratchet mechanism we ...
... wish we had when our kite would dive from the top of it's spectacular climb.

Stop Loss orders are always set regarding the price, but for this discussion I'm going to refer to our account balance instead of price.

So now we launch our Forex kite by placing an order with our broker's web site and we figure the market is going to give us a gain of $300 in our account. So, when we place the order we also place a Stop Loss order at $200 gain, so if the market moves enough (in the right direction) to give us a paper gain of $200+ the ratchet mechanism kicks in to prevent our loss of the initial $200 in profit we made on the way up in case the market makes like a kite and reverses.

The Stop Loss sits there like a cat ready to pounce as soon as (if) the market causes our paper gain to dip below $200...but only after it reaches above that point.

Hey, that's great! I can't lose, right? WRONG!

While a Stop Loss can protect you from losing EVERYTHING in your account (quite possible if you use too much leverage) it can cost you in at least 2 ways.

First, the market price frequently takes a step back and drops for a while on the way to new highs. Your Stop Loss will act like a new trader and hit the panic button and take you out of the market just before it changes direction again and soars like an eagle. You just lost out on huge gains!

Second, your market-making broker is after your money! Your broker is actually trading against you. He essentially buys in bulk and then trades with you and gets 2-4+ pips on every transaction he does with you. That's the "spread", the way he makes money without charging a "commission". Well, what's wrong with that? He has to earn a living.

What you need to know is that your market-making broker can influence the price in his little personal market...and your Stop Loss just told him you are willing to sell if the price hits a specific level and drops for even a second below it! Hey, Mr. Broker! Here's a couple of easy pips for you. Come get 'em!

Okay, your Stop Loss triggered and you have been in and out of the market for a little gain and paid pips both ways...and the market is climbing (without you!), just like you predicted it would, so you jump in again and pay more pips. Oh! Hit me again, that feels good!

Used properly, Stop Loss orders are an essential tool, but to the beginner, they can suck money from your account while you sleep.