Hello traders! This week’s topic might be a bit confusing for new traders, however, it is one of my favorite techniques to enter trades!
In the grand scheme of trading, most traders have heard of a stop loss order. If you haven’t heard of it, you probably shouldn’t be trading yet! A stop loss is used to exit a trade when the price action is going the wrong direction. However, just saying “stop loss” isn’t specific enough. There is more than one kind of stop loss!
Before we get into how to use a stop for entry, we need to define a few things.
What Is a Market Order?
A market order can be used to enter or exit a position; and like everything else in trading it has its pros and cons. The good thing about a market order is that you will get filled, usually immediately. The bad thing is, that you might not like the price you get! When markets are very volatile, like around a big news event, the price you see on your computer might NOT be the market price when it is your turn to get filled. When we get a different price than what we see on the screen, we call that “slippage.” Because of the huge volume in the forex market, slippage shouldn’t be a big issue for you unless you are trying to enter or exit trades in very volatile times.
What Is a Limit Order?
A limit order is where the trader specifies his or her entry or exit price. The good thing about limit orders is, you will get the price you specify, or even better! The bad thing is that you might only get part of your order filled, or even none of it filled! Like I said, pros and cons.
How Do You Use a Stop Loss?
Now, the word “stop” when placed in front of either a market order or a limit order is interesting. Basically, you are telling your broker not to do ANYTHING until the trading price has hit the stop price that you specify. In the following example, you could have gone long at the blue arrow, at a price of about 1.1128, and your stop loss would have gone below the zone, say at 1.1110. This would have given you a risk of 18 pips. IF the candles would have gone DOWN to your stop price, THEN your broker would send a market order to exit your trade.
A stop order is simply an IF-THEN statement. IF the trading price hits your stop price, THEN the broker sends out whatever order (market or limit) that you specified. For a stop loss order, we recommend using a stop market. Here, the same pros and cons apply to the market order – you will get filled, but you may not like the price (slippage.) On stop loss orders, I’m not worried about being stingy, trying to get every last pip out of a trade; I want out of my position if the trade is going the wrong way! Do you want to be stingy or do you want to be OUT??
So, we will use stop market orders for our stop loss, but what about using a stop order for ENTERING a trade? In the following chart example, we’ve identified a zone that we would like to go long in. However, for whatever reasons we didn’t want to enter with a market order. We wanted to wait for the zone to prove that it is holding, and we want to enter our long trade AS PRICE LEAVES THE ZONE. That is where using a stop order for entry makes sense! Remember, stop orders are an IF-THEN statement. In this case, IF the price leaves the zone, THEN I want to be on board. So, we could put our stop price a little bit ABOVE the zone, perhaps at 83.36. But then I have to specify whether I will use a market order or a limit order after the stop price has been hit. For my ENTRIES, I will be a bit stingy. If I used a stop MARKET order, that says I will take any price for my entry, which is not the plan! So, I must use a stop LIMIT order for my entry: give me the price I specify or better, (a limit order!) or don’t fill my entry order at all.
So, with this example: IF the price moves out of my zone and hits my stop price of 83.36, THEN send out a limit order for entry at 83.40. If the trading price moves out of the zone slowly enough, I might even get filled at my stop price of 83.36-because the limit order of 83.40 specifies that price or better. However, if the trading price rockets straight out of the zone, my limit order might not get filled, pros and cons, remember?
Please be aware, you must still have your STOP LOSS order attached to the stop order used for entry! Of course, the stop loss will be a stop market order. Here is the order breakdown:
On the Long side: Use a stop limit order for entry, with the stop above your zone and the limit a couple of pips above the stop price; a stop market for your stop loss, with the stop price a couple of pips below your zone; and a limit order for your profit target, at least three times what your total risk is (distance from your limit price to your stop loss price.)
On the Short side: Use a stop limit order for entry, with the stop below your zone and the limit order a couple of pips below the stop price; a stop market for your stop loss, with the stop price a couple of pips above your zone; and a limit order for your profit target, at least three times what your total risk would be.
As stated earlier, this is one of my favorite entry techniques. Because so many moves start in the overnight hours for where I live, I can place several of these orders before I go to bed and if price goes the right way, I can be in those trades. If price doesn’t move out of my zones overnight, I don’t get into the trade! Hope this helps!