Forex markets are the deepest and most liquid in the world and can be subject to rapid shifts and moves. Forex trading can be very profitable but can also be risky, especially for the beginning trader who is not yet skilled at dealing with the volatility inherent in markets. There are many tools available to manage trading risk. One popular option is using stop losses in forex trading to help reduce the chances of large and permanent losses of capital.

After a trade is placed in the market, the trader immediately files instructions with the broker on a price at which to automatically exit the trade by selling the position if it falls to a certain price. For this strategy to work, the exit price must be below the current price, otherwise the broker would execute the trade right away, eliminating the chance to profit. Traders utilizing this strategy are setting the maximum loss they are willing to accept ahead of time. In other words, this trading strategy is designed to stop losses from getting worse, hence the name stop loss.

Traders should use stop losses to take the emotion out of their forex trading. Many traders, especially beginning traders, suffer from overconfidence, which is the feeling that they are always right. Even the best trading strategy with extensive back-testing and supported by fundamental research will not work 100 percent of the time. The best traders acknowledge this ahead of time. Once a trade has gone against a forex trader, overconfident traders will make excuses and continue to hold the position even as it continues to generate growing losses. There is always more information available and no amount of research can make every trade work as planned. Stop losses force traders to admit that sometimes they are wrong and protect themselves from further losses.

Stop losses also prevent forex traders from worry about breaking even. Another emotional problem that traders encounter is attempting to get their positions back to breakeven before selling them. As with the overconfident example above, worrying about the price where a position was initiated is irrational. New information changes the facts, and the position may never get back to breakeven, and traders may be forced to watch their losses get larger before getting better, or perhaps never recouping losses at all. Using a stop loss in forex trading helps take emotion out of the decision-making process.

Like any trading strategy, stop losses are not guaranteed to work. Sometimes, a position will decline enough to trigger the stop loss, but then almost instantly start rebounding. This phenomenon is known as being stopped out of a position. Traders often feel regret after this happens because they would have been better off never putting the stop loss on in the first place. However, like all trading strategies, stop losses do not work 100 percent of the time. Their purpose is to help limit the odds of massive losses of capital. Also, in the event that a currency starts rebounding after the trader has been stopped out it, a position can always be reestablished. Thankfully, the high liquidity of forex markets makes it easy for traders to quickly change their minds.