A take profit and stop loss orders are popular types of orders used by all types of day traders in the forex, stock, and cryptocurrency market. In this article, we will look at what they are, how to use them well, and some of the top trading strategies to use.
Order types in trading
Before we look at the two types of orders, let us look at what order is and the two main types of orders in the market.
An order refers to a direction you give a broker to buy or sell an asset for you. In the forex market, the broker will execute the market through an electronic communications network (ECN). In the stock market, depending on your broker, they will achieve this through market makers who compete for these orders.
There are broadly two main types of orders in the market. First, there is a market order, which is the most popular order type in the market. It refers to a situation where the broker executes a trade right away.
Second, there is a limit order, where the broker executes a trade at a later time when a preset condition is met. For example, if a currency pair is trading at 1.1200 and you expect it to rise to 1.1300, you can place a buy stop order at 1.1220. In this case, the broker will open a buy trade when the currency reaches 1.1220. In addition to buy stop, other types of orders in trading are sell stop, buy limit, and sell limit.
Another type of order is known as a bracket order. It is implemented by combining several pending limit orders for the same trade.
Take profit order
A take profit is a relatively popular order type in the market that is implemented when a trade is going on. In it, you basically direct a broker to exit a trade after it reaches a certain level.
For example, if you bought a currency pair that is trading at 1.1200, you can decide to exit it when it rises to 1.1260 for a 60 pip profit. Therefore, once you execute the order, you can sit and wait for the outcome to happen.
Alternatively, you can have added a take profit order at 1.1260. Therefore, if the price rises to this level, the trade will be automatically closed with your 60 pip profit. This is how a take profit order works.
The main challenge for a take profit order is when the price suddenly reverses slightly below the preset level. In the example above, if the price rose to 1.1258 and then dropped sharply, the take profit would not have been implemented.
The benefits of a take profit order are several. First, it helps you to automate your trading. This means that you don’t need to sit in front of your computer waiting for a profit level to be reached.
Second, it helps you take advantage of sudden movements. For example, it is not uncommon for a currency pair or a financial asset to gap-up when the market opens and then decline. Therefore, if you have placed a take profit, you will make an instant profit during the gap up.
Third, a take profit order helps you become a more organized and disciplined trader. It does this by letting you set a specific level of making a profit and sticking to it.
Stop loss order
A stop loss order is the exact opposite of a take profit order. Indeed, in my experience, I believe that this order type is more important than the take profit order.
As the name suggests, it is an order type that automatically stops a trade when a certain preset loss level is reached.
For example, if you bought the EUR/USD at 1.2200 and you expect it to rise to 1.2300, you can set the stop loss at 1.1150. In this case, if the trade works out well, you will make a 100 pip profit.
However, if it goes south, it will be stopped automatically at 1.1150, for a 50-pip loss. Therefore, if the price continues to decline to below 1.1100, your account will be protected. However, if the trade declines to 1.1148 and then bounces back to 1.2200, you will have lost money. This is the main challenge for a stop loss order.
Still, it’s benefits usually outweigh the disadvantages. A good example is what happened in March 2021 after the Turkish president, Recep Erdogan fired the country’s central bank governor. When the market opened on Monday, the USD/TRY jumped by more than 15%. Therefore, those traders who were short the currency pair on Friday and didn’t have a stop loss, saw their accounts being wiped out.
Other key events that illustrate the importance of a stop loss order were the 2016 Brexit vote, the surprise Trump election, and the 2015 decision by the Swiss National Bank (SNB) to unpeg the franc from the euro.
To solve the challenge illustrated above, traders use a trailing stop loss order. This is a tool that tracks the price movement. For example, if you bought the EUR/USD at 1.2200 and set a stop loss at 1.1150 and the price rises to 1.2240 and then slides below 1.2200, the initial profit will be retained.
Incorporating limit orders to stop loss and take profit orders
One of the best approaches to using stop loss and take profit orders is to use limit orders. In this, you can place a sell limit trade slightly below where the take profit is. For example, in the USD/SEK pair below you could initiate a buy trade at 8.5959 and a take profit at 8.6732. At the same time, you could add a sell limit at 8.6540. If the price hits the take profit and starts dropping, the latter will become the market order.
Final thoughts
Take profit and stop loss orders are important in the financial market. In this article, we have looked at what they are, how they work, their benefits and disadvantages, and how you can use limit orders to implement them.