Strategies and risk
Using orders to manage risk
Exit orders are a crucial part of your risk-management arsenal – and should always be considered as part of your overall strategy. However, it is important to note that using orders alone won't necessarily limit your losses. Rather, they have to be part of a wider plan.
The chief benefit of setting orders on your open positions is that they can help you stick to your strategy. In the heat of the moment, making the right decision can be tricky. It is often all-too tempting to let losses run or seize profits too early.
A comprehensive risk management plan should outline where you are exiting each position, whether successful or unsuccessful. Your exit orders help ensure that you close each trade at your chosen level, by taking the decision out of your hands.
Let's take a look at some popular methods to control risk using orders.
Stop losses are probably the most popular order type, used to limit losses and manage downside risk.
Our minds can play some nasty tricks on us when we are under pressure, particularly when money is on the line. Stop losses help keep you in line when a position is in the red.
If you enter a position without a stop order, you are opening yourself up to the psychological effects of the 'just one more' bias. This is when you want to believe that a turnaround is on the cards, and don't want to accept that on this occasion, you got things wrong.
Stop losses don't just protect you if a market suddenly reverses and you aren't able to manually close your position. They also act as an additional line of defence against 'just one more' thinking, automatically closing a trade if it hits your maximum loss level.
Remember, though, that you'll need to upgrade to a guaranteed stop if you want to eliminate the risk of slippage.
Being in a winning position is a fulfilling feeling when trading. But human emotion can be dangerous on the markets – and that goes for positive feelings as well as negative ones.
For example, two issues can often plague traders who are sitting on a winning trade. One is reluctance to exit the position at the right level. After all, why would you want to put an end to such a good feeling?
The other is the exact opposite. Instead of letting profits run, many traders want to exit the position and realise them immediately. Again, the thinking behind this is clear. Until you close your trade, those profits won't hit your account, so you're at risk of losing them.
A degree of greed and fear is good when trading. But when they lead to irrational thinking, it can land you in trouble. Using a take profit at your profit target can help you keep discipline, reminding you to stick to your plan instead of going off track.
Trailing stops can play a unique role in your risk management strategy by enabling you to limit downside risk while protecting profits.
As we covered in the Exit orders lesson, trailing stops follow your position if the market moves in your favour, but then remain in place if it moves against you. In doing so, they help limit your losses to a set number of points from the current price of your market.
When opening a position, you can use a trailing stop in a similar way to a standard one. You should know your total maximum loss from a trade, so setting a trailing stop that many points away will close the position if the market immediately moves against you.
However, a trailing stop may not always be the right option when it comes to controlling your risk. Your market may see significant volatility on its way to hitting your profit target, which could mean that you undercut your returns from a trade with a trailing stop.
As an example, say you buy EUR/USD and set a trailing stop 15 points from its current price. Eurodollar rises, then retraces 15 points before rallying to your profit target.
- Your trailing stop would close the position when the market reverses 15 points
- A standard stop wouldn't close the trade, allowing it to continue to your profit target
When you create your risk management plan, it's important to consider which tools you'll employ in which situations. Using stop losses, take profits and trailing stops correctly can make a big difference to your overall bottom line.
Test your knowledge
You buy the FTSE 100 at 6100, with a stop loss 20 points away and a take profit 50 points away. The FTSE then rises to 6200, without dropping. When would your stop loss or take profit execute?
- A Your stop would execute at 6080
- B Your limit would execute at 6150
- C Your limit would execute at 6200
- A At $450
- B At $400
- C At $490
You sell US Crude oil at 4358, with a trailing stop 15 points away. Oil drops to 4341, rises to 4361, then drops again to 4320. When does your stop trigger?
- A 4343
- B 4356
- C 4320