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What Is Stop Loss & How To Use It Effectively?

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Most of the people who have been trading in forex for quite some time understand the concept of stop loss, but there are many who are still not aware of this very important concept and as a result of it end up losing a lot of money in the currency market. The most important thing that needs to be remembered about stop loss is that it is an important tool that can help you maximize your profits. Why?

Simply because of the fact that it is a protection mechanism and if there is no protection, even naïve transactions can cost you a lot of money. This article is dedicated to understanding the concept of a stop loss and how it can be used effectively.
What is stop loss? Well, the answer is quite simple actually. In forex trading, a stop loss is an order that is placed with a broker to sell a currency pair when it reaches a certain pre-determined price level. This means that if you have bought a currency pair and are expecting it to rise to a particular level but the price of the pair starts falling, then there is a level that you can specify that the currency should be sold at to avoid further losses in that pair.

So how can one use stop loss effectively to reduce losses and to consolidate profits in the currency market? Well, in order to do what is listed here, one needs to first understand the psychology of investing. When we are making money, there is euphoria but when we start to lose money there is shock. In the absence of a stop loss, a 10% loss takes the shape of a 40 or a 50% loss.

There are basically two main strategies of employing stop losses. The first is that of having a traditional stop and the other is of having a trailing stop. In case of a traditional stock, when you purchase a currency pair you specify a particular stop loss price value and in case that price level is reached your currency holding is liquidated and you exit the market. The problem with this is that you may lose money even if the price of the pair increased in the beginning but fell afterwards.

To resolve this kind of behavior we have the trailing stop. In case of a trailing stop, you specify the number of pips that you are willing to lose in case the price of the pair you have bought starts to fall. Suppose you have set that to 50 pips while purchasing USD/EUR at 1.2130. This means that your stop loss is at 1.2080. But here lies the difference in case the price of the pair rises upwards your stop loss is also going to move up, thus consolidating your profits. Suppose the price now rises to 1.2150. Here the stop loss would become 1.2100 thus making you a profit of 70pips even if the stop loss is breached.
These are the ways in which a stop loss can be effectively used to consolidate and protect your investment in the currency market.

Proper understanding of the stop loss mechanism is a great way of increasing your long term profits.

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