In the words of the legendary Bruce Kovner, “Whenever I enter into a position, I have a predetermined stop. That is the only way I can sleep….” The practice of using stop losses is one drummed into the minds of every trader entering the business of trading, and for a good reason.
As part of risk management, a stop loss is one of the main tools limiting one’s downside to prevent large losses and account blowups. Contrary to popular belief, not all stop losses are created equally.
Most brokers or platforms employ a basic stop, automatically closing a trade at a loss or profit at a set level. For the most part, this functions efficiently but can work against the trader in the uncommon case of slippage, where the order can be fulfilled at a much worse price than intended.
Hence, the other type of stop is a guaranteed stop-loss order (GSLO), which fills a stop order at a guaranteed price not affected by variable market conditions. The question becomes, is this type of stop-loss more advantageous than a traditional stop loss, and what precisely are the differences? Let’s find out.
Traditional stop losses in forex
Every charting package will have a stop loss function pre-programmed when traders execute orders. Understanding the purpose of a stop loss is simple; it’s primarily a mechanism for controlling losses.
A stop is an order placed in a position to close a trade at a pre-determined unfavorable price automatically. The importance of stop losses cannot be understated. It is the only autonomous method to set a cap on losses without emotional or misguided manual interference.
Interestingly, most traders only appreciate the impact of stop losses for capping their downside. Though actually, stops also bear significance for taking profits as well. When a position moves in one’s favor, they will move the stop loss to specific levels to lock in gains.
If price were to return to these points, a trader has the peace of mind their profits would have been secured, ensuring a favorably profitable exit. Unfortunately, things are rarely perfect in the currencies world as orders don’t always open and close at their requested prices, i.e., slippage.
The basic stop is vulnerable to slippage, meaning a trader could suffer a bigger loss than intended. More often than not, brokers don’t provide any compensation for these occurrences. A guaranteed stop-loss order is a solution to this problem.
Guaranteed stop losses in forex
The GSLO works exactly like a traditional stop, except the order is guaranteed to close at its set price even in the event of slippage. It’s beneficial first to describe a bit about slippage.
This occurrence refers to the difference between the requested price and the actual fulfilled price after execution, resulting in an abnormally wider spread.
The fundamental cause of slippage is when trading activity is at its greatest in high volatility conditions, typically during high-impact news events (and generally when the volume of orders is at their peak).
The impacts of slippage can be both positive and negative. In some instances, a trader can receive a much better order fill; and, in other times, receive a worse price. Of course, the latter comes with unfavorable consequences equating to larger losses.
It becomes beneficial to understand this dynamic by comparing the differences. Let’s consider an example in the next section.
How a guaranteed stop-loss works in practice
Imagine a trader opened a two-lot sell position on USD/JPY at 110.450 with a 60 pip stop at 110.510, equating to a potential loss of $1080 (assuming each pip is worth $18 at the current exchange rate).
If market conditions were normal and the price went against the trader, the stop loss would automatically close at 110.510 with the known $1080 loss. In an unfortunate scenario, assuming a high-impact data release occurred right before execution, let’s imagine slippage occurred, causing the market to close at 110.710 instead (extra 20 pips).
Along with their initial loss, the trader would incur a further downside of $360. If they were using a GSLO, the loss would remain at $1080 no matter where the price closed during the news event.
The main disadvantages of guaranteed stop losses
For all the benefits of guaranteed stop-loss orders, they do come at a cost with some brokers. Fortunately, others like easyMarkets provide the function for free, albeit with some terms and conditions.
Where traders are charged, paying an extra premium increases the overall transactional costs if we also consider the additional burden of spreads or commissions and swaps.
Some brokers do not levy a fee when the order is not triggered, while some do. Also, traders might be required to set the stop a little further away from the current price than they would with a traditional stop, slightly reducing their position size.
Generally, this tool is not available with many brokers, so it’s not necessarily popular with the majority. In virtually all cases, traders cannot place these orders once a position is live, unlike basic stops.
Furthermore, GSLOs are not available with all forex instruments; typically, only the most liquid like the major pairs and some of the minors.
Should traders use guaranteed stop losses?
It’s important to note slippage shouldn’t regularly occur with the vast majority of reputable brokers nowadays connected to substantial liquidity providers to meet the tremendous demand of orders at lightning speed.
Still, slippage may be of concern for some, particularly those more frequent traders who are naturally exposed to all kinds of market conditions.
Some experts have also pointed to the rare instances of gapping, which usually occur on weekends but can, on even rarer occasions, happen during a normal trading day. We may consider this a form of slippage (though not technically) for traders holding their positions over the weekend since the price can open and close at more unpredicted levels than intended.
With both of these considerations in mind, we can see where GSLOs may benefit all types of traders. If the broker provides the order freely, it can be a decent tool to have as a trader.
However, depending on the trading frequency, if a premium is attached, it does increase the overall transaction costs. For the most part, most traders have been happy with the basic stops as slippage is still an infrequent event in the markets with no significant impact in the long run.
In summary, guaranteed stop losses work exactly like traditional stops, except the order will always close precisely at the predetermined levels regardless of slippage. This means losses will always be capped and never deviate away from their expected value.
The usefulness of this function ultimately depends on a trader’s concerns over slippage and their trading strategy. Nonetheless, stops are the cornerstone for risk management in forex to prevent abnormally large losses.