A stop-loss order could help you avoid big losses on your currency investments.
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.
What is 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 currency at a price that you specify.
For example, if you currently hold the USD/JPY currency pair and the price is USD/JPY = 100 (meaning $1 buys 100 yen), you might put in a stop-loss order to sell at USD/JPY = 98. This means that once the exchange rate hits 1 USD = 98 JPY, your brokerage will automatically sell your holding.
Why is a stop-loss order useful?
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%.
Stop-loss orders: An example
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 forex trading is shorting currency. Basically, that means you’re hoping a currency will decrease in value. For example, 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, USD/JPY = 98.
But what if something happens in the world and the exchange rate shoots to USD/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.
To prevent this, you can place a stop-loss order to sell your yen for dollars at more advantageous price — say, USD/JPY = 102. This means that if the price of the currency pair moves against you, at least you won’t lose your shirt from shorting the pair.
Compare providers that can help you set up stop-loss orders
Are there any drawbacks?
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 currency, 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.
What else should I know?
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.