The exchange rate between a currency pair can change suddenly. These fluctuations could transform a good investment into a poor one — and quickly too.
To avoid losing too much on your investments, especially in volatile markets, consider a stop-loss order.
A stop-loss order is a “hedging” tool. When you place a stop-loss order, your brokerage will buy or sell a stock or currency at a price that you specify.
For example, say you buy 50 stocks of Company A for $100 and set a stop-loss order for $80. If the value of the stocks drop below $80, a market order is triggered, and you’re stocks are sold for just under $80.
As another example, if you currently hold the CAD/JPY currency pair and the price is CAD/JPY = 100 (meaning $1 buys 100 yen), you might put in a stop-loss order to sell at CAD/JPY = 98. This means that once the exchange rate hits 1 CAD = 98 JPY, your brokerage will automatically sell your holding.
A stop-loss order is used to limit your losses. If you buy a currency holding and place a stop-loss order 5% below the price at which you made the purchase, then the most you can lose on your investment is 5%.
We’ve already gone over examples of using stop-loss orders to sell currency. Here’s an example for using a stop-loss order to buy currency.
A common strategy in both stock trading and forex trading is shorting currency. Basically, that means you’re hoping a stock or currency will decrease in value.
For example, let’s say $100 buys 1 stock in Company A right now, but you think the stock will decrease in value over the next week. In this case, you could sell the stock immediately, hoping to buy back the stock when it’s less expensive — say, $90. But if the stock value actually increases to $110, you’d be out $10 to buy it back.
To prevent this, you can place a stop-loss order to buy back the stock if it hits, say, $105. That way, if you bet wrongly on the stock price’s movement, you wouldn’t lose as much.
How does this work when trading currencies? Let’s say $1 buys 100 yen right now, but you think the dollar will go down against the yen. In this case, you could sell the dollar for yen immediately, hoping to sell the yen back to dollars at a favorable exchange rate — say, CAD/JPY = 98.
But what if something happens in the world and the exchange rate shoots to CAD/JPY = 115? You have a lot of yen on your hands, but you’d take a big loss if you sold it back for dollars. You can place a stop-loss order to sell your yen for dollars at more advantageous price — say, CAD/JPY = 102. If the price of the currency pair moves against you, at least you won’t lose your shirt from shorting the pair.
Though the stop-loss order is nice in theory, in practice it doesn’t always work perfectly. Your stop-loss order could be triggered at a certain price, but you may not actually get that price — instead, your order will be fulfilled at the next available price. That’s because when you’re trading stocks or currencies, there needs to be someone else trading with you.
In fast-moving markets, the next available price means that you may end up losing more than you originally thought you would.
Some traders recommend that instead of setting stop-loss orders, you should set up price alerts. This way you can decide for yourself what to do next, rather than trigger buying or selling your currency automatically.
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