Understanding Take Profit and Stop Loss
When you place a trade in your trading platform, you also specify two values called ‘Stop loss’ and Take profit’. These values tell your broker to automatically close the trade when it reaches either the desired profit or an area beyond which the loss will be too much.
For example, let us say that you cannot afford a loss of more than 20 pips. Since there is always a chance of losing a trade, you would want to set the trade to automatically exit when it goes 20 pips against the desired direction. So, you specify a certain price as Stop loss (SL), reaching which the trade will be closed automatically. You have to set a stop loss to limit the losses.
Similarly, you set Take profit (TP) value to close the trade automatically, when the trade reaches a certain point in the desired direction. For example, you may want to specify a Take profit of 20 pips after which you want the trade to be closed automatically. Since the price may reverse at any time, You specify a Take profit value to take the profit automatically before the price moves in the opposite direction.
The ratio of the amount of take profit pips to the amount of Stop loss pips is popularly known as the risk to reward ratio. (Know more about risk management in forex here )
Let us see a detailed example. You predict that the price of EUR/USD will go up. You decide to take advantage of it to get some profit.
So, you would want to buy EUR/USD. And you see the Ask price as 1.1345. You decide to take profit when the pair goes up by 20 pips. Similarly, you want to exit out of the trade when it goes down by 20 pips.
So, you will place the order with the following values:
Take profit: 1.1365
Stop Loss: 1.1325
Note that here our risk to reward ratio is 1:1.
There are various types of orders depending on how you enter and exit a trade. Here, we are going to look at the most important types of orders supported by many brokers.
The example order, we looked to understand the stop loss and take profit was a market order. If you instantly enter the market at the best available price, it is called a market order. It is also known as instant execution order.
Limit Entry Order
If you buy below the market price or sell above the market price, it is called as a limit entry order. Here the system will not execute the order immediately, but sometime in the near future when the currency pair reaches a desired price. Since the order is pending until the desired price is reached, it is also known as a pending order. (There is another type of pending order called ‘Stop entry order’ and we will cover that next).
The advantage of a pending order is that you don’t have to sit in front of your computer and keep watching the chart until the market reaches the desired price. You can just place a pending order so that the system will automatically execute the order when the price is reached.
There are two types of limit orders:
Buy Limit: Buying below the market price.
Sell Limit: Selling above the market price.
Let us look at an example for buy limit. Assume that the current price of USD/JPY is 111.25. You don’t want to buy it right away, but you want to wait until the price goes down to 111.15. You predict that the price will rise again after it goes down to 111.15. So, you place a buy limit order and set the trade to execute when the price reaches 111.15.
Sell limit is similar. Let us say that the current price of GBP/USD is 1.2811. You don’t want to go short right away, but you want to wait until the price goes up to reach 1.2825. According to your analysis, the price may come down again with a quick bearish trend after it hits 1.2825. So, you place a sell limit order at 1.2825.