EDUCATION: Hedging vs Stoploss

PEPPERSTONE:USDCAD   U.S. Dollar / Canadian Dollar
Some rookie traders frequently trade without a stop loss because they think they can avoid being stopped out by market swings or rollover. However, if the market moves against them, this technique could result in severe losses. In this article, we'll cover why trading without a stop loss is a bad idea and how stop losses can be used efficiently or, as an alternative, how to employ hedging techniques.

What is a stop loss?
A stop loss is an order that you place on your trading platform to automatically close your position at a certain price level if the market goes against you. For example, if you buy EUR/USD at 1.2000 and set a stop loss at 1.1950, you are limiting your potential loss to 50 pips if the price drops below that level. A stop loss can help you control your emotions and prevent you from holding on to losing trades for too long, hoping that the market will turn around.

There are several reasons why trading without a stop loss is a bad idea, such as:

🔹 You expose yourself to unlimited risk. Without a stop loss, you have no exit plan and you are relying on your gut feeling or luck to close your trade at the right time. However, the market can be unpredictable and volatile, and sometimes it can move hundreds or thousands of pips in a matter of minutes or hours. If you don't have a stop loss, you can lose more than your initial investment and even end up with a negative balance in your account.
🔹 You increase your stress level. Trading without a stop loss means that you have to constantly monitor your positions and worry about every pip movement. This can be very stressful and exhausting, especially if you have multiple trades open at the same time. You may also experience fear, greed, anxiety, anger, frustration, and other negative emotions that can cloud your judgment and affect your trading performance.
🔹 You reduce your profitability. Trading without a stop loss can also reduce your profitability in the long run. By not cutting your losses short, you are letting them eat into your profits and reduce your win rate. You may also miss out on better trading opportunities because you are too focused on your losing trades or afraid to open new ones. Additionally, you may incur higher trading costs due to wider spreads, commissions, swaps, and slippage.

How to use stop losses effectively?

Effectively utilizing stop losses will help you increase your trading profits and stay away from the risks of trading without one. The following advice will help you use stop losses effectively:

🔹 Determine your stop loss level using technical analysis. You can use a variety of technical tools and indicators, including as support and resistance levels, trend lines, Fibonacci retracements, moving averages, volatility indicators, etc., to pinpoint areas where the market is expected to reverse or rebound. Depending on whether you are going long or short, you should set your stop loss just below or just above these levels.
🔹 Use risk management rules to determine your position size. You should always calculate how much money you are willing to risk on each trade and adjust your position size accordingly. A common rule of thumb is to risk no more than 1% or 2% of your account balance per trade. This way, you can limit your losses and preserve your capital for future trades.
🔹Use trailing stops to lock in profits. A trailing stop is a type of stop loss that moves along with the price as it goes in your favor. For example, if you buy EUR/USD at 1.2000 and set a trailing stop of 20 pips, your stop loss will move up by 20 pips every time the price moves up by 20 pips or more. This way, you can protect your profits and let your winners run.
NB: In related ideas I have attached my publication on trailing stop loss and support and resistance for those who would like to know more on those topics

If a trade is having a hard time using stop losses what they can do as an alternative is hedge there position. Similar to how stock traders will use stock options to hedge their risk in the markets.

What is hedging ?

Hedging is a trading strategy that involves opening a position opposite to an existing one, in order to reduce the risk of loss from unfavorable price movements. For example, if you are long on EUR/USD, you can hedge by opening a short position on the same currency pair. This way, if the price goes down, you can offset some or all of the losses from your long position with the profits from your short position.

Why this and not a stop loss ?

The reasons someone would do this is because a stop loss can be triggered by temporary price fluctuations that do not reflect the true market direction. This can result in premature exits and missed opportunities. Moreover, stop loss can expose you to slippage and gaps, which are situations where the market price jumps over your stop loss level and executes your order at a worse price than expected causing you to loss more that you anticipated. hedging your position protects you from those situations. By hedging, you can keep both positions open until you are confident about the market direction and close the losing one when the price starts trending in your direction again.

Things to note: Though you have positions opened in both directions and in theory you should not lose any additional funds once you've initiated the hedge it is worth noting that you can still have fees both positive and negative from swap fees at rollover depending on the direction and the asset you are trading. I will be doing a post soon on heading as a stop loss as a standalone topic and also swaps and rollover.

C Nicholas Downie

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