Using orders for risk management

Types of orders play a fundamental role in your arsenal for managing trading risks and should form the foundation of your trading approach. However, it’s essential to understand that orders alone cannot guarantee loss limitation—they need to be part of a broader trading strategy.

The primary benefit of setting different orders on your open positions is their ability to keep you aligned with your trading strategy. When markets heat up, decision-making can become challenging. It’s often tempting to let losses run or close winning trades prematurely.

A well-structured risk management plan should clearly define when to exit each position—whether profitable or not. Different order types ensure trades are closed at your predetermined levels, taking the emotional burden of decision-making off your shoulders.

Let’s dive into the most commonly used order types for managing risk:

• Limit Orders

• Stop Orders

• Trailing Stop Orders

Limit orders

Limit orders, also known as take-profit orders, are primarily designed to secure your profits. Being in a profitable position is an exhilarating experience. However, emotions - positive or negative - can be a double - edged sword in trading.

Traders with winning positions often face two significant challenges:

1. Reluctance to exit at the right level:
   Exiting a winning trade can be difficult. Why end something that feels so rewarding?

2. Closing too soon:
   Conversely, some traders rush to realize their profits prematurely, fearing that they might lose them if the trade isn’t closed.

Example of Take-Profit Orders:
Take-profit orders can help traders maintain discipline by automatically closing trades at pre-set profit targets, encouraging them to stick to their strategy.

While a touch of greed and fear can be healthy motivators in trading, when these emotions drive irrational decisions, they can lead to losses. Take-profit orders act as safeguards against such impulses.

Stop orders

Stop orders, commonly referred to as stop-loss orders, are perhaps the most widely used tools for limiting losses and managing downside risk.

Under pressure, our minds can play tricks—especially when money is at stake. Stop-loss orders help enforce discipline, particularly when a trade is in the red. Entering a trade without a stop-loss order exposes you to the psychological trap of "just one more chance," where you hold on, hoping for a market reversal, instead of acknowledging a misstep.

Stop-loss orders also protect against sudden market reversals, especially when you’re unable to manually close your position.

Beware of slippage:
Stop-loss orders are executed at the market price, which may differ slightly from your intended level due to slippage. Despite this, they remain an invaluable tool for maintaining risk control and minimizing losses.

Trailing stops

Trailing stops offer a unique advantage in your risk management strategy by limiting downside risks while protecting upside gains.

Sometimes, traders aim to maximize profits by keeping trades open longer but still want to limit potential losses. Trailing stops can be ideal in such scenarios, dynamically protecting gains as markets move in your favor and capping losses if they reverse.

Unlike standard stop or limit orders, trailing stops let you specify a distance (in pips) from the current market price rather than a fixed level. This distance adjusts automatically as the market moves in your favor. If the market moves against you, the order triggers at the nearest available price based on market liquidity.

How to use trailing stops:

• Set a trailing stop when opening a position, much like a standard stop-loss.

• Define your maximum acceptable loss, ensuring the trailing stop will close the position if the market moves unfavorably.

Potential drawbacks of trailing stops:

Trailing stops aren’t always ideal, particularly in volatile markets. Price fluctuations might trigger the stop prematurely, preventing the trade from reaching its profit target.

Example:

Imagine buying EUR/USD and setting a trailing stop 15 pips away:

• If the price rises and then drops by 15 pips, the trailing stop closes your position.

• With a standard stop-loss, the trade would remain open, potentially reaching your profit target.

Key takeaways

When crafting a risk management plan, carefully consider which tools to use in various scenarios. Proper application of stop-loss, take-profit, and trailing stop orders can significantly impact your overall trading success.