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Using orders to manage risk
Order types 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 must be part of a wider plan.
The chief benefit of setting different order types on your open positions is that they can help you stick to your trading 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. Different order types help ensure that you close each trade at your chosen level, by effectively taking the decision out of your hands.
Let’s take a look at some of the most commonly used order types to manage risk.
Limit orders
Limit orders are primarily used to protect profits, which is why they're sometimes referred to as take-profit orders. 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 a 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 realize them immediately. Again, the thinking behind this is clear. Until you close your trade, those profits won’t hit your trading 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.
Stop orders
Stop orders (also known as 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 also protect you if a market suddenly reverses and you aren’t able to manually close your position. Stop orders are executed at market and consequently may be subject to slippage.
Trailing stops
Trailing stops can play a unique role in your trading risk management strategy by enabling you to limit downside risk while helping to protect profits.
Maybe you’re having a hard time simply taking profit at a particular point; maybe you want to keep pushing the envelope to see where you can take your trade but at the same time you want to limit your losses. In this type of scenario, you may want to consider a trailing stop. A trailing stop dynamically protects your profits on the upside and losses on the downside.
Unlike a limit or stop, a trailing stop allows you to specify the number of pips from the current rate, as opposed to the rate at which to trigger a market order. The number of pips automatically trails your order as the market moves in your favor. If the market moves against you, then a market order is triggered, and the trade is executed at the next available rate depending on liquidity.
When opening a position, you can use a trailing stop in a similar way to a standard stop. 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 moves against you by that much.
However, a trailing stop may not always be the right option when it comes to controlling your trading 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 pips from its current price. The pair rises, then retraces 15 pips 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.
